Fallout from the credit crunch

1
Fallout from the credit crunch

• FEI Breakfast Seminar
• 28 November 2008

2
Financing in a Post-Crunch World

• Larry Prentice
• Senior Vice-President, Transaction Advisory
  Services
• Ernst Young Inc.

3
Credit Crisis Creates Chaos

• Where we are
• How has the game changed
• What do we do about it

4
As the Snowball Started .

• On September 5th, Canadian banking executives met
  for roundtable discussions
• The overall view is that the subprime mortgage
  crisis and credit crunch will significantly
  impact global banking
• Credit spreads and costs of financing will
  increase
• Days of cheap money are over
• Need to sort out how banking regulation will be
  conducted
• Overall, the banking industry is facing
• more transparency and scrutiny of their balance
  sheets
• an expectation that regulatory capital
  requirements will be increased

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and then picked up speed

• On October 8th, 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
• 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 caught up to the changes,
  resulting in a Canadian prime rate of 4.0

6
market liquidity evaporated

• Banks lending to customers slowed down
• Tighter controls
• Higher pricing
• New loans not available to new customers
• Banks lending to other banks REALLY slowed down
• Risks appeared where never seen before
• Consequences critical to lending and borrowing
  institutions
• Government involvement at unprecedented levels

7
Bank Confidence Index

• 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

• The spread, currently around 160 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

8
Obtaining Financing

• Businesses will 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
• Businesses can improve their odds of obtaining
  funding by being in a perpetual state of
  readiness to be able to market themselves and
  take advantage of market/transaction volatility
• A compelling growth story (reflecting the current
  economic environment) which must be supportable
  by hard data
• Prepare and substantiate information required by
  lenders to ensure greater credibility throughout
  the financing process
• Provide far more access to comprehensive
  information about the business and the industry
  than in the past
• Invest in new, independent information to support
  business plan forecasts and communicate the
  growth potential and value creation
  opportunities to investors
• Enable management to devote sufficient time to
  running the business
• To succeed in this market, businesses must
  recognize that the path to funding starts
  significantly ahead of the formal financing
  process

9
Industries under Stress

• Real estate
• Project financing problematic
• Retail consumers are wary
• Forestry and Automotive
• Nuff said
• Mining
• Base metal prices lower
• Exploration financing has dried up
• Retail
• General consumer confidence is problematic

Lender confidence in all business areas is low
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Financing is more conservative

• Lending is being governed by greater discipline
  as underwriting standards have become more
  stringent resulting in lower multiples, higher
  pricing and tighter covenants
• Cash flow lending has shifted to lower debt to
  EBITDA multiples
• Senior debt currently in the 2.5 3.0x range
• Up to 1.5x incrementally available from mezzanine
  lenders
• This compares with senior multiples of 3.5 4.0x
  and total debt of 5.0 5.5x approximately a year
  ago
• 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

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Pricing of Financing

• The chart below illustrates the growth in lender
  conservatism, particularly with respect to second
  lien loans

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Recent Example Grain Handling Co. (GHC)

• Description A company focused on grain
  handling, processing and distribution for
  domestic and export markets and a provider of
  supplies and services to farmers.
• In August 2006 GHC obtained C113 million of
  senior debt financing including an operating line
  and term loan
• Revolver Pricing 3-month BAs 150 basis points
• Term Loan Pricing 3-month BAs 175 basis
  points
• In 2008, GHC sought additional financing from its
  lending syndicate in the total amount of C155
  million
• One large entity dropped out of the banking
  syndicate as pricing was too low, and another
  U.S. based bank declined to participate in the
  Canadian market
• A 4-bank syndicate (2 existing, 2 new) is
  financing the operating line with a niche lender
  providing the term loan
• Revolver Pricing 3-month BAs 225 basis points
• Term Loan Pricing 3-month BAs 250 basis
  points

13
Canadian Real Estate Market

• Transaction volume has fallen significantly since
  Q3 2007 in Canadas three largest markets
• Transaction values on a significant downtrend
  since Q4 of 2007
• Due to financial issues in the U.S., these trends
  will likely continue

source RealNet Office, Retail, Industrial,
Apartment, Hotel GVA, GTA, GCA markets
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Mortgage Spreads Widening

• Bank of Canada rates on downward trend since Q3
  of 2007
• Spreads between Bank of Canada benchmark rates
  versus mortgage rates have widened dramatically
• Lending rates for investment properties have
  increased modestly
• Current rate of approximately 6.0
• Loan-to-value rates have declined to
  approximately 60 or less

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Impact on Canadian Financing Scene

• New incentives for transactions
• Funds and investors need for liquidity
• Problems from unexpected places
• Supplier stability an issue for producers
• Customer stability requires increased vigilance
• Fewer financial alternatives
• Take out financing a thing of the past
• More candidates for restructuring
• Higher bar for refinancing means fewer companies
  qualify

16
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

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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
• Understand degree of counterparty risk
• Review investment policy
• Align maturities with requirements
• Limit exposure to any single point in time
• Ladder portfolio to reduce exposure to short term
  market dislocations

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Treasury focus on short term liquidity (contd)

• Manage counterparty risk
• Traditional approach of heavy reliance on debt
  ratings needs to be reviewed
• 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

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Managing Financing Requirements

• Be aware of the supply and demand constraints
• Be prepared for increased 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

20
Managing Financing Requirements (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

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Conclusion

• Be wary
• Expect to be surprised
• Be flexible
• Have alternatives available
• Be prepared
• Start early
• Revisit assumptions regularly

22
Financial reporting implications of current
market conditions

• Gary Miller
• Partner, Assurance Advisory Business Services
• Ernst Young LLP

23
Fair value in financial reporting - the debate

• Debate about merits of fair value in financial
  reporting
• Contributed to the current credit crunch
  conditions, or
• Or has the credit crisis highlighted the benefits
  of fair value in financial reporting while
  exposing some of its limitations
• Fair value measures necessarily reflect
  conditions at the balance sheet date, they are
  not forecasts of future market prices
• Nonetheless investors want current fair value
  information and that transparency about fair
  values is important

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Recent market events accounting and reporting
considerations

• Valuation of Investments
• CICA Amendments to Canadian Accounting Standards
• Trading securities are carried at fair value
  and changes in fair value are included in
  earnings.
• Reclassifications out of trading were not
  permitted abuse of hindsight
• Accounting Standards Board has introduced
  amendments to CICA 3855 in response to the
  similar recent IAS 39 amendments
• Permit reclassifications of securities (excluding
  derivatives) out of trading (to AFS or HTM)
• in rare circumstances and
• no longer held for the purpose of trading
• To be effective for reclassifications made on or
  after July 1, 2008 provided statements have not
  previously been issued
• Amendments implemented on emergency basis without
  public comment period
• Amendments posted to the CICA AcSB website

25
Recent market events accounting and reporting
considerations

• Year-end reporting points to watch
• Internal controls over financial reporting
• Credit risk in derivatives valuation
• Impairment of goodwill and indefinite life
  intangibles
• Employee benefits
• Debt
• Risk and other disclosures in financial
  statements, MDA

26
Recent market events accounting and reporting
considerations

• Internal controls over financial reporting
• Current market conditions have changed the nature
  and extent of risks and the related internal and
  disclosure controls procedures necessary to
  address them
• Processes and controls relating to the
  development of inputs and assumptions for the
  valuation of significant assets and liabilities
• Review of assets for recoverability or impairment
• The need for external specialists (e.g. valuation
  or actuarial expert) to assist in the
  determination of the recorded amounts of certain
  assets and liabilities
• Processes and controls for monitoring compliance
  with covenants
• Internal auditors should reconsider their current
  audit plans in light of any new or increased
  risks facing the company

27
Recent market events accounting and reporting
considerations

• Credit risk and derivatives
• Non-performance risk (including credit risk) of
  both parties impacts fair value
• Recent events may have effected the credit
  worthiness of both parties to a derivative
  instrument
• Deterioration of a derivative counterpartys
  credit worthiness or companys own
  creditworthiness can cause hedge ineffectiveness

28
Recent market events accounting and reporting
considerations

• Impairment of goodwill and indefinite life
  intangible assets
• Impairment test for goodwill and indefinite life
  intangible assets may be required to be performed
  on more than an annual basis
• Tests for impairment of goodwill are required
  between annual tests if circumstances suggest it
  is more likely than not that the fair value is
  less than its carrying value
• Tests for impairment of indefinite life
  intangible assets are required between annual
  tests if circumstances indicate the asset might
  be impaired
• Current economic and market conditions increase
  the risk that impairment indicators exist

29
Recent market events accounting and reporting
considerations

• Employee benefits
• Current market conditions suggest that benefit
  plan accounting expense and funding requirements
  will increase
• Increased credit risk and reduced liquidity in
  the marketplace have likely affected the fair
  value of plan assets used in determining funded
  status and resulted in experience losses
• These factors will also make it challenging to
  choose an appropriate discount rate
• Assumed returns on plan assets should reflect
  current expectations about long term rates of
  return

30
Recent market events accounting and reporting
considerations

• Debt
• Compliance with provisions in covenants
• Ability to refinance maturing debt
• Classification of debt as long-term vs. current

31
Recent market events accounting and reporting
considerations

• Disclosure requirements
• Re-evaluate financial statement and MDA
  disclosure around interest, FX, credit and
  liquidity risks
• Re-evaluate financial statement and MDA
  disclosure around capital management
• Re-evaluate critical accounting estimates
  disclosures
• Assess going concern based on current market
  conditions

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Taxes Creating Value and Minimizing Risk in
Turbulent Times

• Bruce Sprague
• Partner, BusinessTax Advisory Services
• Ernst Young LLP

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Agenda

• Tax perspective of the current economic
  conditions
• Issues to consider
• Tax strategies to preserve cash

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Tax perspective of the current economic conditions

• 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

35
What is the impact to your business?
Acquisitions
Cash
Divestments
Tax function
Current market conditions
Accounting for tax
Closures
Structures
Refinancing or Recaps
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Cash

• Converting tax assets to cash
• Review capital and current expenditures
• Utilization of losses
• Tax instalments, payments and refunds
• Realizing or securing tax benefits
• SRED tax credits
• Carry back of losses
• Clearing out Capital Dividend Account before
  losses
• Crystallize CGE while eligible

37
Cash

• Deferral of Tax
• Timing of recognition of profits
• Capitalize new business
• Intellectual property planning
• Repatriation and Cross Border
• Tax efficient repatriation of cash
• Review existing transfer pricing and financing
  structures

38
Cash

• Factoring receivables
• Sale and lease back
• Loss planning
• Crystallizing losses when required and preserving
  losses and adjusted cost base
• Accuracy of forecasts
• Ensure tax assumptions reflect business
  expectations in a downturn can tax payments be
  deferred, are instalments correct

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Cash

• Commodity taxes - Apply a variety of strategies
  to improve commodity taxes cash flow
• Offsetting payroll remittances against
  GST/HST/QST refunds
• Accelerating GST/HST/QST input tax credit
• Have early billing date on transactions for
  GST/QST purposes
• For significant purchases with GST/HST/QST
  payable, use a legal entity that is in a net
  GST/QST payable position for the purchase (and
  re-supply)

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Review of current structure

• Is the current group / tax structure optimal for
  the current downturn?
• Matching profits and losses
• Reviewing tax structures for revised profit or
  loss forecast
• Taxable reorganization of corporate group
• Revisit management compensation planning
• Transfer pricing
• Determine if intercompany transactions are being
  created to deal with cash shortages and to
  crystallize losses in certain jurisdictions
• Review current practice to ensure compliance with
  transfer pricing rules
• International Assignment Policy
• Review international assignment policies to
  introduce cost efficiencies
• Social security tax agreements should be reviewed
  for employer tax savings
• Are there outstanding tax equalizations for
  assignees that should be completed

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Refinancing or recaps

• Refinancing
• Debt/equity swaps ensuring debt is not
  inadvertently extinguished and taxed under debt
  forgiveness rules
• Thin capitalization determine how the position
  will change subsequent to refinancing and changes
  in the balance sheet

42
Divestitures

• Preparation for exit
• Tax efficient restructuring to package
  assets/companies for sale, including elimination
  of intercompany debts
• Maximizing value when selling companies with
  losses by preserving tax attributes
• Consider US golden parachute provisions for any
  US executives
• Tax efficient exercise of incentive compensation
  plans
• Using an insolvency process to effect the sale of
  assets
• Tax planning to ensure divestitures are tax
  efficient
• Creation of losses to offset gains on disposal
• Any unrealized losses in the group that can be
  accessed?
• Consider deferral mechanisms on sale such as
  capital gains reserves and timing of sale

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Governance

• Fred Withers
• Western Canada Managing Partner
• Ernst Young LLP

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Issues Questions

• Why companies are continually blindsided by risk
• The role of the board and the audit committee in
  risk oversight
• MDA disclosures in volatile and uncertain times

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Why companies are continually blindsided by risk

• The most devastating risks come from where no one
  is looking
• Pressure to perform in the short term obstructs
  companies ability to manage risk
• There is a link between risk appetite and
  remuneration

46
The role of the board and the audit committee in
risk oversight

• The boards role in overseeing strategic risk
• The audit committees role in overseeing
  financial and operational risks

47
The boards role in overseeing strategic risk

• Ensure the presence of an effective risk
  organization
• Influence, empowerment of risk management
  function
• Sound risk identification and independent risk
  measurement
• Effective monitoring of risk positions,
  supportive of mitigation actions
• Review and approve key risk policies
• The balance between growth, risk and returns
• Risk measurement framework, e.g., risk metrics
  for quantifying exposures
• Review/approve aggregate and specific risk
  appetite and related risk limits
• Review risk positions routinely review and
  approve exceptions
• Consider effectiveness of controls and mitigation
  strategies

48
The audit committees role in overseeing
financial and operational risks

• How audit committees should address risks
  associated with the financial crisis
• Conduct a going concern analysis
• Review investments, investment policy and the
  treasury function
• Review company defined benefit pension funds
• Talk to the external auditor
• Address increased disclosure requirements
• Reserve for litigation risk

49
The audit committees role in overseeing
financial and operational risks

• How audit committees can help to enhance risk
  oversight
• Continuing to ask out-of-the-box questions to
  identify risks
• Finding a balanced approach to bottom-up and
  top-down risk identification
• Ensuring risk is owned by executives throughout
  the business
• Ensuring that an integrated picture of risk
  drives audit and compliance
• Testing that company culture does not run counter
  to risk management efforts

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MDA disclosures in volatile and uncertain times

• Strategy and risk management
• Risks and uncertainties
• Concentrations of risk
• Results analysis
• Liquidity and capital resources
• Critical accounting estimates
• Fair value
• Off-balance sheet arrangements and variable
  interest entities
• Going concern

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Contact Information

• Fred Withers
• 604 643 5419 Fred.G.Withers_at_ca.ey.com
• Larry Prentice
• 604 643 5416 Larry.W.Prentice_at_ca.ey.com
• Gary Miller
• 604 891 8350 Gary.Miller_at_ca.ey.com
• Bruce Sprague
• 604 891 8415 Bruce.F.Sprague_at_ca.ey.com

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Q A