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Financial Executives International When the taps run dry: getting things done during a credit crunch November 24, 2008.

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Presentation on theme: "Financial Executives International When the taps run dry: getting things done during a credit crunch November 24, 2008."— Presentation transcript:

1 Financial Executives International When the taps run dry: getting things done during a credit crunch November 24, 2008

2 Current State of the Capital Markets FEI: Managing Funding Requirements November 2008 Ernst & Young Orenda Corporate Finance Inc. Brian Allard

3 2 Table of Contents Current Market Conditions – Subprime Impact Market Stabilization – Money Market Indicators Canadian Perspective Availability of Financing Treasury – Focus on Short Term Liquidity Financing Today – Conclusion

4 3 Current Market Conditions – Subprime Impact

5 4 Where We Are Today Despite repeated efforts by Congress and the Federal Reserve, including the passing of the $700 billion bailout and the takeover of Fannie Mae and Freddie Mac and the reduction in the benchmark rate, the U.S. economy continues to slide towards recession Consumers continue to face enormous pressure to cut spending due to an uncertain housing market and weak job market According to Moodys, of the 75.5 million U.S. households that own their homes, 12 million, or 16%, owe more than their homes are worth

6 5 Where We Are Today (contd) In an effort to stimulate lending in a concerted effort, the Fed, together with the European Central Bank, the Bank of Canada and 3 other central banks, cut benchmark rates on October 8, 2008 Despite these efforts, the International Monetary Fund states that the global economy is headed for a recession in 2009 and estimates losses from the financial crisis to be $1.4 trillion (worldwide losses are currently just below the $1 trillion mark)

7 6 Subprime Related Losses The following chart illustrates the $920 billion of asset write-downs and credit losses by financial institutions (including insurance companies), of which $695 billion are from more than 100 of the worlds largest banks and securities firms Source: Bloomberg To date, approximately $825 billion has been raised to meet these losses of which approx. $710 billion has been raised by banks and securities firms

8 7 Subprimes Impact on Financial Services The impact of the increasing defaults in the subprime market began to trickle into the financial services sector in late 2006 and early 2007 In July 2007, credit rating agencies began to downgrade certain mortgage backed securities resulting in the evaporation of the subprime market Financial institutions were forced to write-down the book value of the securities held as assets on their books According to Bloomberg, banks losses from the U.S. subprime crisis and ensuing credit crunch stand at approximately $695 billion as of November 11, 2008 Some of the highest losses have been incurred by U.S. banks such as Citigroup ($68B), Merrill Lynch ($56B), UBS ($44B) and Wachovia ($97B) Canadian banks CIBC and RBC have also had writedowns

9 8 Subprimes Impact on Financial Services (contd) As a result of these write-downs which began in the summer of 2007, lenders further tightened borrowing terms to preserve their remaining capital Covenant lite loans disappeared while the use of PIKs became heavily restricted The subprime crisis came to a dramatic head when the Federal Reserve facilitated the purchase of Bear Stearns by JP Morgan in the spring of 2008 And credit markets, which began seizing up after BNP Paribas SA halted withdrawals on three funds in August 2007, froze after Lehman Brothers Holdings Inc. collapsed on September 15 2008, negatively impacting lenders confidence of repayment

10 9 Funding Scarcity The fallout of the credit crisis has been a scarcity of capital as the lender base continues to shrink and remaining banks look to governments for help in repairing their balance sheets U.S. loan issuance, particularly leveraged and investment grade loans, have significantly declined since the credit crunch took hold in the summer of 2007 Source: Reuters LPC/Deal Scan

11 10 Funding Scarcity (contd) In the secondary market, the average bid for multi-quote term loans is at its lowest point ever at 75.44 suggesting that loans may be purchased for just over 75 cents on the dollar As of October 2008, it appeared that the bailout had not stopped the downhill trend in bid prices The bid/ask spreads for both U.S. and European loans also indicates lower levels of liquidity As of October 2008, spreads were 219 basis points in the U.S. and 266 basis points in Europe Source: Reuters LPC/Deal Scan

12 11 Defaults in the Global Bond Markets The amount of defaults are expected to increase with Moodys forecasting default rates to climb to 6.3% globally and 7.2% in the U.S. As the number of defaults climbs, so too does the U.S. speculative grade default rate which ended at 3.4% in Q308, up from 2.5% in Q208 A year ago, the leveraged loan default rate was 1.2% Source: Moodys Investors Service

13 12 Market Stabilization – Money Market Indicators

14 13 Market Indicators Although LIBOR has come down significantly from its high of 4.81% on October 10, 2008, credit conditions remain tight 3-month U.S. LIBOR is currently at levels not seen since October 2004 The cause for the decline is primarily due to the provision of virtually unlimited funding from central banks as well as government offered bailouts and guarantees to financial institutions Source: BBA, Bloomberg

15 14 Market Indicators (contd) Prior to the credit crunch which set in towards the middle of last year, the average spread between the 3-month U.S. LIBOR rate and the effective Federal funds rate was approximately 12 basis points On October 10 th, 3-month U.S. LIBOR peaked at 4.82% representing a spread over the effective FFR of over 4.00% LIBOR is currently on a downward trend Source: The Federal Reserve, Bloomberg A narrowing of this spread to 25 basis points would be positive however forward markets indicate that this will not happen until the middle of 2010

16 15 Market Indicators (contd) The daily effective federal funds rate is a volume-weighted average of rates on trades arranged by major brokers and is calculated by the Federal Reserve Bank of New York Source: The Federal Reserve, Standard & Poors via Demystifying the Credit Crunch Arthur D. Little

17 16 Market Indicators (contd) A key indicator of credit conditions is the LIBOR-OIS spread The LIBOR-OIS spread is a comparison between 3-month U.S. LIBOR and the overnight index swap (OIS) rate A widening spread indicates that banks believe other banks to which they are lending have a higher risk of default so they charge a higher interest rate to offset this risk Source: BBA, Bloomberg The spread, currently around 170 bps, compares with 87 bps on the last trading day before Lehman declared bankruptcy, and an average of 11 bps in the five years prior to the financial crisis

18 17 Canadian Perspective

19 18 Canadian Perspective The Canadian market has also been impacted by the financial crisis which gripped the U.S. The spread between the 3-month Canadian T-bills and 3-month BAs widened significantly in Q2 and Q3 of 2008 as stock markets plunge by historic amounts and central banks worldwide attempt to unfreeze the credit markets Source: Bank of Canada

20 19 Canadian Perspective (contd) On September 5 th, Canadian banking executives met for roundtable discussions and the overall view is that the subprime mortgage crisis and credit crunch will significantly impact global banking CEO of Royal Bank of Canada Gord Nixon said that credit spreads and financing costs will remain high, The days of cheap money are over, and credit spreads across the board have, and will continue to significantly increase the cost of financing. Rick Waugh, CEO of Bank of Nova Scotia said that it needs to be determined which regulators will oversee financial companies in the U.S. and that process could last a year or more Overall, the banking industry is facing more transparency and scrutiny of their balance sheets and the expectation is that regulatory capital requirements will be increased

21 20 Canadian Perspective (contd) On October 8 th, the Bank of Canada, Federal Reserve, European Central Bank and 3 other central banks lowered interest rates in an unprecedented coordinated effort to ease the economic effects of the credit crisis The BoC cut the overnight rate by 50 bps to 2.5%, however, Canadas major banks did not initially follow suit and only lowered their prime rates by 25 bps to 4.5% citing high borrowing costs in global credit markets On October 21, the BoC cut the overnight rate again by 25 bps to 2.25% Canadian banks followed suit resulting in a Canadian prime rate of 4.0% Three major interrelated developments are having a profound impact on the Canadian economy. First, the intensification of the global financial crisis has led to severe strains in financial markets. The associated need for the global banking sector to continue to reduce leverage will restrain growth for some time. Second, the global economy appears to be heading into a mild recession, led by a U.S. economy already in recession. Third, there have been sharp declines in many commodity prices. The outlook for growth and inflation in Canada is now more uncertain than usual. - Bank of Canada press release dated October 21, 2008

22 21 Availability of Financing

23 22 Availability of Financing Credit markets in Canada are changing daily Many international and U.S. institutions have pulled away from the Canadian market or are in a state of uncertainty: CIT GMAC Wachovia GE Capital Deutsche Bank Remaining institutions may be open for business but there is effectively no secondary market to syndicate or sell down exposure Lending institutions are focused on optimizing the allocation of scarce capital

24 23 Availability of Financing (contd) Capital that may be made available for new funding has changed dramatically, as illustrated below:

25 24 Availability of Financing (contd) Lending is being governed by greater discipline as underwriting standards have become more stringent resulting in lower multiples, higher pricing and tighter covenants The impact of the credit crunch to senior cash flow lending has resulted in lower debt to EBITDA multiples which are currently in the 2.5 – 3.0x range with up to 1.5x incrementally available from mezzanine lenders Moreover, subjective addbacks, adjustments or normalizing entries to earnings are also coming under greater scrutiny Borrowers are being faced with increased due diligence from an ever shrinking base of lenders resulting in elongated deal timetables Fully underwritten transactions are history Borrowers are being forced to piece together club deals to meet capital needs

26 25 Availability of Financing (contd) Debt/EBITDA multiples have decreased significantly in the large corporate market (EBITDA > $50MM) going from 4.9x in 2007 to 3.7x in Q3 2008 The virtual disappearance of second lien loans and the reduction in the availability of traditional senior debt financing are the primary causes for the decline While subordinated debt has increased as a portion of the overall capital structure in the middle market (EBITDA < $50MM), second lien loans have virtually disappeared Source: Standard & Poors, LPC Average Debt Multiples of Large Corporate Loans (EBITDA > $50M) Average Debt Multiples of Middle Market Loans (EBITDA < $50M)

27 26 What Can Get Done? Asset based loans are becoming increasingly attractive to certain borrowers Loans > $30MM pose a syndication risk Market flex risk on terms, structure, pricing, etc. Spreads in the range of 300 bps Cashflow loans to borrowers of strategic relevance to lenders Leverage < 3.0x Industry specific Sponsor makes deal easier Spreads in the range of 400 bps

28 27 Treasury – Focus on Short Term Liquidity

29 28 Treasury – Focus on Short Term Liquidity Current market dislocations require Treasurers to more closely focus on short term liquidity A more disciplined approach is in order - Stronger focus on quality of investments Better understanding of organizations liquidity requirements

30 29 Treasury – Focus on Short Term Liquidity (contd) A portfolio approach to manage risk makes sense: Understand the liabilities, i.e. the liquidity needs of the company Measurement/forecasting needs to be done on a weekly if not daily basis Manage investments or borrowings to meet that liability stream Manage portfolio to: 1. Understand degree of counterparty risk Review investment policy 2. Align maturities with requirements Limit exposure to any single point in time Ladder portfolio to reduce exposure to short term market dislocations

31 30 Treasury – Focus on Short Term Liquidity (contd) Manage counterparty risk Traditional approach of heavy reliance on debt ratings needs review Additional due diligence required Clearly define goal of investment policy: income generation, or secure and efficient store of liquidity Increase requirement for lower yielding but more secure investments Governments BAs from Canadian chartered banks Careful review of money market funds

32 31 Financing Today – Conclusion

33 32 Financing Today – Conclusion To obtain financing in todays market, businesses need to be cognisant of the supply and demand constraints with which they are faced Transactions are subject to more scrutiny and aggressive due diligence requirements The terms under which different lending institutions are willing to lend may vary significantly To succeed in this market, businesses must recognize that the path to funding starts significantly ahead of the formal financing process

34 33 Financing Today – Conclusion (contd) Plan early to deal with debt maturities Expect increased pricing and tighter covenants Expect a reduction in unutilized credit availability/carve back of acquisition and expenditure accommodations In large syndicates, plan for fall-out of fringe participants Review short to mid-term capital needs and strive to preserve capital Review working capital cycle Capital expenditures Sale of non-core/redundant assets

35 Turning adversity into opportunity Aroon Sequeira

36 35 Stress Pendulum Depending on your companys financial strength, the current environment presents both opportunities and risk. Cash flowCash burn Acquisition opportunities Court supervision Stakeholder management Supplier stability Market Reassessment Working capital Liquidity management Portfolio optimization Cost reduction Asset impairment Divestitures Business unit closure Capital restructuring

37 36 3 Components of An Organization Core Operations and Activities Redundant Operations and Activities Non-Core Operations and Activities Core: Those operations, assets, and people (OAPs) who are critical to the operating company. Redundant: Those OAPs who represent a critical drain on limited capital and should be eliminated in an orderly or immediate fashion. Non-Core: Those OAPs who individually or collectively represent a valued asset not core to the company, but could be monetized to generate capital for the ongoing entity.

38 37 Corporate Hygiene Cost management Head count management Capital expenditure management Be Proactive with Scenario Analysis

39 38 Assess Counter Party Risk Capital sources Supply chain Customers Insurance Ongoing Due Diligence is a Must

40 39 Manage Cash Liberate cash from working capital Weekly rolling cash flow Review dividends and share buy back programs Sell viable non-core divisions Liquidate non-viable or excess assets Sale lease back arrangements Cash is King

41 40 If Theres Trouble on the Horizon… Proactively manage lender relationships Proactively assess divestiture opportunities Consider risk theory Time is of the Essence

42 41 Carpe Diem Opportunistic Acquisitions EBITDA assumptions Multiples Balance sheet Increased due diligence Increased orphaned public companies Increased creative structures Opportunistic hires There Will Be Many Opportunities for Bold Moves

43 Valuation in Todays Economic Environment Al Burant

44 43 Valuation Challenges Fair Value standard refers to values in an Active market and assumption of a Willing seller of a control position Current market capitalizations often not determinative of value, including: Reference to own stock price Reference to comparable public companies Reduced number of market transactions as reference points Some transaction multiples may reflect distressed sale Limited number of analyst reports and updated financial forecasts

45 44 What We Have Seen Reliance on Discounted Cash Flow models Impact on Cash Flow Projections Revenue assumptions Timing of cash flows Margin assumptions Working capital assumptions Capex assumptions Impact on Weighted Average Cost of Capital (WACC) Cost of debt Cost of equity Leverage assumptions Dealing with Uncertainty: Scenario Analysis and Sensitivity Analysis Use of independent specialists

46 45 Potential Impacts on Financial Reporting Annual Goodwill Impairment Test Interim Goodwill Impairment Test Long-Lived Asset Impairment Tests

47 46 Considerations in Current Market Going Private Transactions Formal Valuation Fairness opinion Responding to Takeover Bids Share Repurchase

48 47 Conclusion Cant paint all scenarios with a broad brush – need to review the facts and circumstances relative to each Company and to each Reporting Unit in todays economic environment.

49 Tax Issues Peter Stephen

50 49 What are we seeing in the marketplace? The current economic climate is a crucial time to leverage tax opportunities to create and preserve value Tax strategies may need to shift in focus to: Releasing cash Reducing costs Efficient refinancing/restructuring Restructuring may be more complex than ever before given the predominance of highly geared tax-driven structures

51 50 Cash Converting tax assets to cash Realizing or securing tax benefits Deferral of Tax Repatriation and Cross Border

52 51 Cash Factoring receivables Sale and lease back Loss planning Accuracy of forecasts

53 52 Cash Commodity taxes - Apply a variety of strategies to improve commodity taxes cash flow: Offsetting payroll remittances Accelerating input tax credit Have early billing date on transactions For significant purchases with GST payable, use a legal entity that is in a net payable position for the purchase (and re-supply) Where significant amounts of GST are payable, consider use of the administrative FAST-TRACK Process with CRA Use of Leasing Co. for PST purposes

54 53 Accounting for tax Tax provisions – accuracy; review Impairments – how will they impact tax accounting? Deferred Tax Assets – should they continue to be recognized?

55 54 Review of current structure Is the current group / tax structure optimal for the current downturn? Transfer pricing – is methodology consistently applied? International Assignment Policy - is it too expensive?

56 Staying on course Kent Kaufield

57 56 Improve earnings and operating margins How profitable is the organization? Improve asset and capital management How efficient is the organization? Increase revenue and market share How does the organization grow? Stay aligned to your business drivers Successfully enter new markets Develop new products & services Improve existing products & services Acquire new customers Strategic acquisitions Revenue optimization Cost optimization Acquisition integration efficiencies Minimize taxes Optimize working capital Improve asset efficiency Non-core divestitures Effective capital programs Strengthen corporate governance Improve risk management and internal controls Improve reputation and brand Do external stakeholders have a favorable view? Business drivers Make our business better Keep us out of trouble

58 57 Companies should take a strategic view in developing initiatives to manage in the current economic environment Maintaining business success Business challenges Credit environment Falling consumer confidence Inflation concerns Declining revenue and profits Decreased equity values General uncertainty Lessons learned Focus on cost and revenue optimization vs. cost reduction Improve operations, including execution of major capital projects Focus on protecting company brand and reputation Prioritize and enhance strategic market opportunities Focus on timely and transparent communication with all major stakeholders An effective cost reduction program will focus on delivering sustainable results that can be leveraged when economic conditions change Results from programs initiated in previous economic downturns suggest that companies should balance short-term results with long-term business strategies

59 58 An effective transition of initial program into sustainable on-going function A vision which is fully aligned with corporate strategy and wholeheartedly backed by executives A robust benefit tracking process that is embedded within existing processes to drive accountability and realization Experienced program management and change management equipped with a robust methodology and supporting tools that drive execution Design a portfolio of initiatives that creates an integrated Roadmap for change An hypothesis driven approach based on experience that focuses efforts on areas with highest benefit potential Sustainable ECR Program A comprehensive ENTERPRISE COST REDUCTION program should be implemented – cut with a purpose and a plan Key ECR program success elements 1 2 3 4 5 6

60 Q & A

61 Contact Information

62 Brian Allard Senior Vice-President Ernst & Young Orenda Corporate Finance Inc. (416)943-2665 Aroon Sequeira Partner Ernst & Young Orenda Corporate Finance Inc. (780) 633-5200

63 Contact Information Al Burant Senior Manager, Valuations Ernst & Young LLP (780)412-2385 Kent Kaufield Partner Ernst & Young LLP (403) 206-5378

64 Contact Information Peter Stephen Partner Ernst & Young LLP (780)441-2445

65 Ernst & Young Assurance | Tax | Transactions | Advisory Transaction Advisory Services (TAS) Our Transaction Advisory Services team works with some of the worlds largest organizations, fastest growing companies and private equity firms on some of the biggest and most complex cross-border deals in the global market. We can help you achieve the growth, performance improvement and returns your stakeholders expect. We offer integrated, objective advisory services that are designed to help you evaluate opportunities, make your transactions more efficient and achieve your strategic goals. We have an extensive global reach, with 7,000 transaction professionals worldwide, and the experience of thousands of transactions across all markets and industry sectors. We can bring together the people you need, wherever you need them, to focus on helping you achieve success throughout the transaction lifecycle and beyond. Whether its a merger, acquisition, strategic alliance, divestment, equity offering or restructuring, we offer you the advice you need to help you make the right deal at the right price at the right time. Its how Ernst &Young makes a difference. For more information, please visit © 2008 Ernst & Young Orenda Corporate Finance Inc. All rights reserved. Proprietary and confidential. Do not distribute without written permission. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. 0000121108TTSLBA

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