The Canadian distressed market: low interest, low leverage leads to low distress
January 2014 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
The Canadian economy, taken as a whole, has weathered the financial storm ravaging the global economy over the last several years. As a consequence, the Canadian distressed investing, distressed lending and distressed M&A markets have been only modestly more active than in better times.
Until more recently, this relatively calm economy was, in part, a consequence of: (i) a sizable, strong and sustainable energy sector (oil and gas in particular); (ii) a tremendously stable group of Canadian financial institutions that continued to offer credit even to the residential real estate market and small businesses; (iii) successfully avoiding a residential real estate collapse; and (iv) the absence of a consumer or commercial credit bubble with businesses, in particular, experiencing relatively historically low levels of leverage. These factors, together with sustained historically low interest rates, have contributed to muting distressed M&A activity.
What does this mean for the distressed investor or lender in Canada? These activities are like every other segment of the economy; subject to the whims of market ‘supply and demand’. A shortage of supply increases pressure to compete for deals. The result is weakened deal terms and higher purchase price multiples, especially on the larger, most scarce transactions.
Canadian distressed investors participate in ‘out-of-court’ and ‘in-court’ sale processes. They provide distressed lending for higher returns and also to gain toeholds as leverage for a downturn opportunity. It is nothing new or unique globally, but the interest in this market in Canada is increasing as a number of new deals get clocked and build awareness of the opportunities and provide for a ‘normal’ transaction pattern.
There are a mere handful of major Canadian based funds targeting distressed investment, lending and M&A from inside the Canadian market. There are far more US based players participating in Canadian deals on an ad hoc, or opportunistic basis with a modest measure of success.
Where is the activity?
An uncharacteristically public fight for control and protection of interests – the Mobilicity case
Mobilicity’s financial woes continue to push it through a Court sanctioned and supervised sale process. Mobilicity is a carrier in the Canadian wireless telecommunications business. Prior to filing for protection under the Companies’ Creditors Arrangement Act (CCAA), Mobilicity tried to sell itself to a competitor, TELUS Corporation, on a ‘going concern’ basis for C$380m. There was noteholder support for the deal with Telus and a plan of arrangement filed by Mobilicity pursuant to the Canada Business Corporations Act (CBCA) being accepted by the requisite majority of noteholders and adjudged by the Ontario Superior Court of Justice as being fair and reasonable. The deal failed because Industry Canada would not approve the transfer of Mobilicity’s spectrum licences to TELUS Corporation. Without Industry Canada’s consent to the transfer of the licences, the transaction could not be completed.
Mobilicity then sought and was granted protection under the CCAA on 30 September 2013. A Court supervised sale process is currently underway. The case has the usual features: a stay of proceedings, DIP lending and a Court supervised sale process.
In the background of the Mobilicity case a battle has been waging between Catalyst Capital Group Inc. on the one hand, and the debtor and other noteholders of various ranks. Catalyst, one of Canada’s biggest and most successful players in the distress market, is the holder of more than $60m of Mobilicity’s first lien notes representing, according to Court records, about 30 percent thereof. Catalyst pre-emptively sought relief against Mobility for ‘oppressive conduct’ under the CBCA on the basis that Mobilicity was acting unfairly and prejudicially to Catalyst’s interests as a major stakeholder. In furtherance of this fight Catalyst took the relatively unusual step of filing creditor initiated or ‘hostile’ CCAA proceedings against Mobilicity.
In broad terms Catalyst alleged that other stakeholders with their interest residing in a holding company of Mobilicity were attempting to manipulate the structure of the proposed sale transaction that would disregard the separate legal interests of the other corporate entities, thus elevating the priority of their claims relative to other creditors. Catalyst’s requested relief included asking the Court to disband the ad hoc committee of debtors formed under the initial CCAA order on the basis that it was comprised of ‘conflicted’ debt holders, and that it be replaced with a new committee that included Catalyst. The Court-appointed CRO of Mobilicity opposed the requested relief on the basis that to grant Catalyst’s requested relief would be ‘destabilising’ and would ignore the support and value the other stakeholders had provided to Mobilicity. Catalyst had also asked for a review of the original DIP loan in order to have alternative arrangements, including their own, considered. Catalyst believed that the working capital constraints imposed on Mobilicity were creating a spiralling negative effect on the restructuring and accordingly, wanted additional capital and a shorter sale process. Mobilicity attempted to characterise Catalyst’s arguments as an attempt by Catalyst to take control of the restructuring and sale process to the detriment of other stakeholders. Catalyst was unsuccessful in convincing the Court to reopen the DIP loan process. In the end, the Court affirmed that Mobilicity’s own CCAA proceedings should continue.
The Mobilicity sale process bid deadline is 9 December 2013. The case is worth following because of the uncharacteristically open conflict among the debtor and different stakeholder groups all around the DIP loan and sale process.
It is no secret that the mining resource sector is under tremendous negative pressure from dropping commodity prices. This is occurring globally as fallout from the European financial crisis, slow industrial recovery in the US and China’s economic engine shifting from fifth gear to second gear have all visited a plague on the global mining industry.
Canadian miners with domestic and global operations alike are struggling as commodity prices decrease to close on, or below, per unit production costs. Losses build up because it is extraordinarily difficult to temporarily shut down a producing mine, or find other efficiencies during operations. Inevitably, mines are starting to be closed, which will reduce supply and restore some normalcy to commodity prices. Even as overheated costs ‘correct’, much damage has been done.
The public equity markets’ support for the sector is soft, leveraged finance is scarce, traditional investors are cautious and strategic buyers with cash are not venturing forward and continue to hold cash. Despite the press reports to the contrary, private equity interest in the mining/resource sector is slow for several reasons; not least of which is the ability to manage an exit in the required fund lifecycle.
If the commodity cycle downturn continues, it is reasonable to predict there will be significant distressed investment opportunities in this sector in Canada and globally. That said, mining, like any commodity business, is not for the inexperienced. It will be interesting to see who will be at the table as distressed opportunities present themselves. The obvious answer is distressed M&A by strategic buyers. Historically, mining has been a longer window investment and is susceptible to both rational and irrational commodity market volatility. If there is an opportunity then a solution is likely to present itself. It is not clear whether strategic buyers will open their purse strings and become acquisitive or whether specialised funds already in the resource sector will tackle distressed assets on their own. At this point it is as likely that financial players currently holding mining assets may actually be the vendors.
More recently there appears to be the potential for some ‘joint venturing’ between financial and strategic players in the mining sector. The difficulty with such JVs is matching the exit date for the shorter term financial player with the traditionally longer hold of the strategic buyer. In order for such JVs to work, the two sides may need to agree on an exit date for the financial player after a predetermined term or financial milestone, with price being calculated based on a predetermined contractual formula.
Credit bidding increasing in use in Canada?
The use of credit bidding in a Canadian Court supervised sale process (whether in reorganisation or receivership proceedings) continues to grow. Canadian court-supervised sale processes in large cases have adopted many of the standard features of the US sale process: e.g., with a competitive or auction model being utilised. ‘Toe-hold’ or ‘loan-to-own’ investors buy positions in order to gain leverage in acquiring a debtor either through credit bidding in a competitive sale process or by converting debt to equity in a reorganisation.
There have been a limited number of cases in Canada in which credit bidding has been considered by the Courts. In the White Birch Case, a Court supervised auction lead to the stalking horse bidder being successful with key elements of its purchase consideration being attributed to credit bidding. Parlay Entertainment Inc. is another example of successful credit bidding in a Canadian context. In that case, the stalking horse bidder, M. Projects Assets S.A., successfully acquired Parlay through an auction process with a credit bid. It is important to note that Canadian Courts have only recognised credit bidding in circumstances where the asset being sold was fully charged by the security underlying the credit bid. Equally, the credit bid process should not be used as a foreclosure process and for that reason it will likely only be used within the context of a competitive sale process.
Credit bidding is here to stay in Canada and, accordingly, is fully expected to be used by distressed investors as an effective tool in pursuit of deals.
The usual cycle of decay and renewal continues. There are always stressors in specific economic sectors and opportunities in that regard are episodic.
It is hard to predict the sectors that will encounter headwinds but the constant march to an online retail environment continues to take its toll on large and small Canadian retailers. It is an adaptive and innovative economy for retail and the pace is fervent. It will be interesting to see whether this pattern presents further viable distressed investing opportunities. Who wants to buy a retail business that failed for a lack of adaptation and innovation? Even the best turnaround alchemist can’t make gold from a buggy whip.
David F.W. Cohen is partner at Gowlings LLP and a member of the Executive Board of the Turnaround Management Association where he serves as the TMA Corporate Secretary and a member of its Operations Committee. He can be contacted on +1 (416) 369 6667 or by email: email@example.com.
© Financier Worldwide
David F.W. Cohen