by Kevin A. Fougere, Janan Paskaran, Amanda Balasubramanian
The Canadian high-yield debt market has continued to see increasing activity over the past year, with six publicly announced deals to date in 2013, as equity markets in Canada remain weak and investors continually look for yield-related investment products. These recent offerings cover a wide range of sectors, including healthcare, grain processing and media, with a notable increase in the number of oil and gas–related offerings.
High-yield bond issuances have always signified a greater degree of risk in respect of an issuer’s ability to repay the debt, given their nature as non-investment-grade securities with ratings typically lower than BBB (Moody’s). However, recent issuances by oil and gas-related issuers would appear to evidence a greater market of issuers with a higher risk profile that may be able to tap this market. With equity markets being relatively soft, oil and gas producers have had difficulty attracting sufficient capital to fund their capital expenditure programs. To make matters more challenging, the traditional Canadian first lien secured debt market has remained conservative in its approach to the amount of first lien leverage it will allow borrowers to incur, because Canadian oil and gas lending banks have remained disciplined and not overly aggressive with their oil and natural gas price decks and risk models. Issuers without sustained oil and gas production have also historically been challenged to raise capital in the Canadian high-yield market; yet several recent issuances would suggest that near-term production may be sufficient to satisfy investors’ risk profiles. Recent offerings evidence a growing demand for issuances by oil and gas-related issuers – for example, offerings by oilsands companies Southern Pacific Resource Corp. ($260 million at 8.75%) and Athabasca Oil Corp. ($550 million at 7.50%), environmental waste company Tervita Corporation ($200 million at 9%) and oil and gas issuers Trilogy Energy Corp. ($300 million at 7.25%) and Paramount Resources Ltd. ($300 million at 7.65%).
The soft equity markets have also made financing M&A transactions more difficult for acquirors. However, the growth of the high-yield market in Canada has allowed issuers to finance acquisitions through the use of such debt. An example of this is the recent offering by Canadian Energy Services & Technology Corp. of $225 million seven-year senior unsecured bonds, which was primarily used to repay a bridge facility that was part of a US$240 million acquisition of a private specialty chemicals company.
One of the advantages of the Canadian market is that an issuer can size a deal as small as $75 million and as large as $600 million; in the United States, a pricing penalty is typically levered on any deals smaller than $250 million. Accordingly, for issuers looking for a relatively smaller amount of high-yield debt, the Canadian market may be more appropriate. The smaller deal size naturally leads to a smaller group of investors, making it more likely for a Canadian issuer to be able to negotiate covenants that may be less traditional and more tailored to their individual needs, as has been evidenced in recent deals. For example, in Athabasca’s recent Canadian dollar offering, the asset sale covenant and several critical financial definitions were expanded beyond the typical formulation and customized to Athabasca’s needs.
Covenants in Canadian high-yield deals have historically followed the U.S. model, though Canadian covenants have tended to be tighter and provide greater protection to investors as a result. However, recent issuances have demonstrated more flexibility and pragmatism in Canadian covenants than in the past and, as noted above, are able to tailor certain covenants. For example, typical high-yield covenants would limit the ability of an issuer to distribute cash to its shareholders; however, the covenants being utilized in certain issuances have recently included the flexibility to permit dividend-paying companies to continue to pay dividends (with some flexibility to continue to increase the amount of such dividends) so that equity participants will continue to support the shares of such issuers. This was evidenced by the recent issuance by Canadian Energy Services & Technology Corp. Moody's has also recently noted a general deterioration (from an investor’s perspective) in the covenant protections in Canadian high-yield issuances, which, from an issuer’s perspective, means greater flexibility.
In the context of recent high-yield bond issuances by Canadian issuers, in both the Canadian and the U.S. investor markets, Canadian banks that hold first lien secured debt of such issuers are willing to allow their borrowers with oil and gas reserve-based borrowing base loans to incur this additional high-yield debt (whether or not it is secured); however, the cost of that is typically a "grind" on the maximum borrowing base value that the senior lenders will attribute to the borrower’s producing assets. The magnitude of the grind varies, but 25% of the borrowing base is typical in the Canadian market, though that can vary depending on the size of the offering and the interest rate (and amortization schedule, if any) of the high-yield bonds. The alternative, though not as common, would be to set aside a portion of the proceeds of the high-yield issuance into a debt service reserve account to cover interest on the bonds over a period of time, typically two years. Either way, Canadian banks are recognizing that the traditional first lien debt market is insufficient to satisfy the debt load requirements of many of their Canadian clients in capital-intensive industries. And the Canadian banks are broadening and developing their own capabilities in bringing these products to their clients.
The Canadian market has also seen issuances with certain features that have been utilized in the United States and elsewhere, such as second lien secured debt and PIK (pay-in-kind) debt to address the demands of the market.
Some recent Canadian secured second lien high-yield issuances have also differed from typical U.S. secured second lien deals in two important aspects. First, while second lien secured bondholders typically have an indefinite standstill on enforcing their security (until the first lien holders are paid in full), they are in the meantime usually afforded all the rights of unsecured creditors because the standstill does not apply to the exercise of those rights. However, in a few recent Canadian high-yield transactions, that structure was altered so that the standstill would apply to all the rights of secured lien holders (secured or unsecured), but the standstill period was not indefinite and had a relatively short life (with a range from 60 to 120 days). Second, and this concept applies to unsecured high-yield bonds as well, the traditional first lien permitted debt basket is the greater of a fixed number at closing and a percentage of either a company’s consolidated net tangible assets or a company’s EBITDA (or some derivation of either). However, in some recent high-yield bond issuances of Canadian oil and gas producers, a third element has been added to the permitted debt basket – the borrowing base. In this context, the borrowing base is essentially the highest amount that the first lien revolving lenders are willing to lend at any particular time in the future. This gives first lien debt flexibility to the issuer, but conversely the bondholders have less certainty about how much first lien debt will rank ahead of their bonds. Canadian investors in high-yield bonds appear to have become comfortable with this concept on the basis that, as noted above, Canadian banks are relatively disciplined and conservative in determining the maximum commitment amount available to their borrowers through the relative "black box" borrowing base concept.