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How to avoid the death spiral of converts The Canadian convertible Overview

Over the past decade a wide range of hybrid securities Today the convertible market in has have become available leading to growth in non-traditional ballooned to over $14 billion; however, despite the The Canadian marketplace financing options including convertible debentures. Factors popularity of convertible debentures, few issuers or such as rising markets and appetite for truly grasp the -term associated with has created an opportunity for Canadian to these complex products. is home to over $14 billion in this as an effective financing tool.

Convertible debentures became especially popular publicly traded convertible amongst investors in the last decade as they provided a source of regular income through , had a degree of downside protection not found in equity and offered debentures and is continuing upside for capital appreciation in rising equity markets. to grow. However, there is little knowledge of the fundamental risks of issuing and owning these complex products, particularly in times of distressed market conditions.

2 The Canadian convertible debentures market How to avoid the death spiral of converts 3 Overview of the Canadian What is a convertible debenture? convertible debentures market

The Canadian convertible debentures market is often However, in recent years the issuance of new convertible viewed as a high yield market generally composed of debentures has slowed down significantly. A cooling of sub- grade securities. The majority of Canadian investor interest in these products presents significant convertible debentures issuances are not rated by challenges to existing issuers looking to refinance their rating agencies. maturing convertible debentures.

Canadian mid-cap companies and real estate investment Exhibit 2: Convertible issuances by year trusts have been particularly active using convertible (Source: FP Infomart) debt in the past decade as an opportunity to finance acquisitions or new projects, enter new markets, or fund continuing operations.

A convertible debenture is a hybrid facility composed of Convertibles are priced based on their rate two components (debt and equity), each bearing a unique (internal ) and the conversion (price at $2.1B $1.8B $1.2B and reward profile. The debenture can be converted which debt is convertible into equity at any time before into by the holder, usually at their . By adding and is typically 20-40% premium to their current A cooling of investor interest in these the convertibility option the issuer pays a lower interest trading price). Some of the advantages and disadvantages products presents significant challenges 2012 2013 2014 rate on the compared to if there was no option of convertible debentures to both the issuer and the to existing issuers looking to refinance to convert. investor include: Note: Quoted figures represent new convertible debenture issuances their maturing convertible debentures. between January 1 and August 30 of each year. Exhibit 1: Advantages and disadvantages of convertible debentures

Advantages Disadvantages Issuer Allows for higher leverage without the Difficult to restructure at maturity if the ’s burden of traditional secured debt; typically price is depressed; potential dilution risk to existing no pledged as ; flexibility shareholders at maturity if converted while attributable to conversion features is depressed Investor Exposure to a company’s credit with an Subordinated in proceedings to senior profile; limited downside risk by secured debt; loss of inherent premium associated with separating the security from a full decline convertible feature if companies share is depressed in the stock price

4 The Canadian convertible debentures market How to avoid the death spiral of converts 5 What are the risks relating to The issue convertible debentures?

When the underlying stock price of a company increases, A fundamental risk with convertible debentures is when For all the advantages that convertible debentures Shareholder dilution and effective loss of a convertible debenture investor’s is “in the the underlying stock price decreases materially, which can have for issuers, they do come with a level of risk, risk ” because they have the opportunity to convert result in challenges due to lower share . particularly closer to the maturity date and / or when the Companies with near-term maturing convertible at a lower conversion price and ultimately sell the equity Such an event can considerably limit a company’s equity company’s equity is depressed and credit markets are debentures will often see a depression in their share price at the higher market price. As long as the and equity-related options. more challenging. Some of the common risks relating to as the market prices in the risks associated with maturity. leveraging the convertible debenture issuance is accretive convertible debentures include: If a company does not have the liquidity to settle or the then the underlying stock price will generally increase, Exhibit 3 below demonstrates the dilution effect of ability to refinance their convertible debentures then essentially providing the debenture holder with a higher redeeming debentures for equity at maturity when a they may be forced to repay the holders through the . company’s current share price is below the conversion Companies with near-term maturing convertible contractual conversion of the debentures to equity, which price implicit in the convertible debenture. The following is debentures often face difficulties in refinancing as noted in Exhibit 3, may cause significant dilution to based on a convertible debenture with a $1,000 face value their of debt as there are often no material existing shareholders. and assumes a conversion price of $20.00. unencumbered assets for a senior secured lender to lend against. sales and additional capital are often the first Formal risk Exhibit 3: The convertible debenture dilution effect (Source: Deloitte analysis) claim for . Companies who find themselves unable to amend, $20.00 extend or refinance their near-term maturing convertible debentures may be compelled or forced into a formal restructuring arrangement. Maturing debenture issuances $15.00 may also trip debt covenants with senior lenders. e pric

$10.00 share t rr en Cu $5.00

$- 0 100 200300 400500 600 700 800 900 1,000

Number of shares at conversion

As at August 30, 2014 the Toronto (TSX) The “series” trading as “busted” have several reported market values on 195 “series” of convertible striking similarities: debentures. Of these “series”: • The majority face maturities in 2016/2017 • 80% were trading below their conversion price • Many companies have more than one “series” • 26% were trading below 50% of their conversion price compounding the refinancing issue and could be considered “busted” • Most companies have embarked on a number of • 9% have a in excess of 20% - an acquisitions or development projects that have thus far indicator which demonstrates the market believes failed to be accretive to the underlying stock price refinancing may be an issue • Most companies have been confronted by restructuring realities - cuts, cost reduction and refinancing risks that often plague and cause a drag on the trading price, and • Discounted trading prices severely limit equity options for the refinancing of the maturing debentures

6 The Canadian convertible debentures market How to avoid the death spiral of converts 7 What happens next? What options are available?

Through consultation with senior executives from Not having a refinancing strategy in place can lead to a Amend and extend Reorganization and arrangement under the CBCA companies with outstanding convertible debentures, number of unpredictable and negative effects. To this end, An amend and extend is not a true refinancing strategy Section 191 of the CBCA refers to “reorganization” of but rather an option that is available to issuers to reach often in conjunction with BIA or CCAA Deloitte has noted that refinancing options are becoming an issuer must take great care to send the correct signal out to existing holders of the debentures to propose new proceedings whereby the debt and equity of a significantly challenging. In particular, companies that have to the market that a well-contemplated and executable terms in exchange for an extension of the maturity date. can be amended. convertible debentures with a decreased stock price are refinancing strategy has been put in place. Typically, in Canada most debenture holders are finding it difficult to refinance at all. Some have gone as investors, making it a widely held instrument. The execution Section 192 of the CBCA governs “arrangements” where far as seeking foreign markets for refinancing. As maturity nears, available options become more limited. of an amend and extend strategy can be challenging and “it is not practicable for a corporation that is not insolvent While we believe that each and every refinancing strategy will often require the company to entice holders with to effect a fundamental change in the nature of an The result is that the Canadian market has a significant will be dependent on the , the shareholder base, better terms on the coupon and the conversion premium. arrangement under any other provision” of the CBCA. amount of unsecured convertible debt outstanding and the state of the market, these are options that we In addition, an amend and extend strategy may require Where a corporation applies to court for an order under this which will require thoughtful strategic options to refinance. expect will guide the majority of the strategies: a concession fee to entice the brokers and investors to section, the court may make any interim or final order “it Based on our conversations in the market, it is apparent support the proposal. thinks fit”. that credit markets are relatively strong, making it an ideal time to proactively begin considering strategic Examples of recent amend and extend arrangements include: refinancing options. Company Royal Host Limited Royal Host Limited Royal Host Limited IBI Group Inc. Clarke Inc. Clarke Inc. Several companies have begun divesting non-core assets Series D: 5.9% Series B: 6.0% Series C: 7.50% 7.0% coupon; $19.17 conversion 6.0% 6.0% coupon; to pay down debt; however, many face restrictions on coupon; $6.19 coupon; $4.76 coupon; $4.87 price coupon; $7.50 conversion Debenture conversion price conversion price conversion price $7.50 price series paying down their convertible debentures prior to that of conversion the more senior tranches. price Value of $29M $24M $41M $45M $62M $62M debentures Deloitte anticipates that a large number of convertible Previous 30-Jun-14 31-Oct-15 30-Sep-18 31-Dec-14 31-Dec-13 31-Dec-18 debentures issuers will soon be faced with the need to maturity date consider strategic options to refinance their debt, with Announcement 13-May-13 13-May-13 29-Nov-13 7-May-14 19-Jun-12 13-Nov-12 an expected increase in the following activities: date of intent to amend • Amend and extend agreements between issuers and 30-Jun-2019 31-Oct-2020 N/A 30-Jun-2019 31-Dec-2018 N/A debenture holders date • Restructuring capital under Canada Business New maturity 30-Jun-2019 31-Oct-2020 N/A 30-Jun-2019 31-Dec-18 N/A Corporation Act (CBCA) sections 191 or 192 date Increase coupon Increase coupon Amend change of First proposal: Same as old terms Extend 6.50% coupon (reorganization and arrangements) by 0.35%; Reduce by 0.25%; Reduce control provision with a consent fee equal to 7% to be maturity Eliminate ability to • Issuance of higher yield debt and equity Proposed conversion price conversion price issued as a earning convert; Consent terms to $3.50; Remove to $3.50; Remove 7% interest fee equal to 2.5% • Increased activity by distressed debt, special situation change of control change of control and other sophisticated investors looking to capitalize provision provision Increased coupon Increased coupon Amended change Option A - Promissory Note: Equal Same Plan not approved on market adjustments, and by 0.35%; Reduced by 0.25%; Reduced of control provision to $195.65 per $1,000 of principal coupon; • Formal restructuring under the Companies’ conversion price to conversion price amount, payable Dec 31, 2016 and Consent $3.50; Removed to $3.50; Remove bearing 7.0% interest per annum. fee equal Arrangements Act (CCAA) or the and change of control change of control Option B - Promissory Note + to 6%; provision provision Reduced Conversion Price: Maturity Insolvency Act (BIA) Result (i) Promissory note equal to $86.96 extended per $1,000 of principal amount, payable Dec 31, 2016 bearing 7.0% interest per annum and (ii) the reduction of the conversion price from $19.17 to $5.00 per common share.

8 The Canadian convertible debentures market How to avoid the death spiral of converts 9 However, while section 192 specifically limits use of this Convertible debenture issuance CCAA provision to corporations that are “not insolvent” the Companies may have the ability to replace their existing The CCAA is a effective restructuring mechanism for courts have taken a facilitative approach to the application series of convertible debentures with a new offering insolvent companies. The CCAA has very broad powers of section 192 and the solvency requirement. given that there is an existing holder base. The issuance and can be effectively leveraged for companies facing of new convertible debenture series for companies with much larger restructuring issues than simply convertible Recently, there has been an increase in use of the shares trading below the original conversion price is often debentures. Some of the events which typically lead to a arrangement provisions of the CBCA to restructuring expensive as the markets are not willing to price the filing include: companies and groups that are effectively insolvent. For coupons at the same rate as before and the conversion • Missed debt or interest or a looming example, in 2012 Yellow Media, with approximately price is very dilutive. Resets of conversions prices may also • inability to pay $200M issued tranches of convertible debt, successfully be required. • The expiry of a debt facility without recapitalized under the CBCA following approval from the • replacement available Superior Court of Quebec. Equity issuance • -law suits, and/or Companies may have the ability to issue additional • General business conditions which render the current Interim and final orders issued by courts have included: equity if the market is receptive; however, this form of operating model unsustainable provision for the compromise of ; share and refinancing is often costly in terms of fees and results in issues; sale or investor solicitation processes; conversion the dilution of the existing shareholder base. This option The CCAA can be used to facilitate or implement various of debt to equity; and, court-ordered stays of proceedings is typically only available to companies with an existing restructuring measures, such as the sale of surplus or against parties from terminating contractual arrangements well above the level of convertible obsolete assets, the disposition of an unprofitable business or enforcing their rights as creditors. debentures to be retired. segment, the disclaimer of unsustainable contracts or leases, and the compromise of secured and unsecured Perceived advantages of section 192 arrangements are the sponsor debts. For debenture issuers, the CCAA allows companies avoidance of formal insolvency proceedings under the BIA Having a private equity sponsor, as a standby facility to to negotiate amended payment terms, including debt or CCAA, a potentially streamlined restructuring process, refinance convertible debentures is an advantageous tool reductions, or equity conversions with convertible debt and reduced court and stakeholder supervision. to restore market confidence that the issuer will be able holders. to meet the obligation when it becomes due. This will We suggest that if consensual arrangements to amend reduce the dilution effect and allow the company a longer The CCAA is by far the most comprehensive restructuring and extend with convertible debenture holders cannot be window to find a permanent solution. mechanism available to larger, more complex companies achieved, then the arrangement provisions of the CBCA and groups to respond to an event triggered by maturing could be used to propose a compromise, organize and However, timing is an important factor. Identifying when to convertible debentures. Yet, the CCAA can be expensive; hold meetings of note holders to vote on the arrangement, seek out a sponsor is crucial as it will affect the magnitude it is a court driven process, requires significant time and obtain court approval of the arrangement, and to have of stand-by fees on the back-stop facility and the market energy from and eventual buy-in from the benefit of a stay of proceedings during the process to pricing and equity options of the underlying facility. If the all stakeholders. prevent creditors from taking action which could destroy of the issuer is heavily levered with secured . debt, this will add additional to the pricing of the refinancing.

10 The Canadian convertible debentures market How to avoid the death spiral of converts 11 The Deloitte approach Choosing a path

Frame Select Companies must act quickly – they must thoroughly Deloitte can help Develop a tailored strategic option analysis framework Outline supportable and independent recommendations to contemplate available strategic options and develop Deloitte’s multi-disciplinary team of professionals has a from which to identify, collate, diligence, and evaluate management pursuant to the refinancing or restructuring an executable plan to send a clear and positive signal deep understanding of the convertible debentures market. options available depending on the company’s current initiative selected. Provide management with a description to the market. As this paper illustrates, there is no one We can help to independently assess your company’s financial health and refinancing opportunities. of the pros and cons of alternate options in the event of a way to respond to the challenges related to convertible position, and work with you to identify and develop a restructuring event and how each stakeholder group may debentures. However, proactive management of pending range of executable options in a comprehensive and Model be affected. debt maturities is essential to ensuring there is sufficient integrated call to action. Leverage a flexible financial model from which the time to address issues before they become a crisis. company can evaluate the financial efficiency of available Implement options over time. Develop specific output criteria to Drive the implementation of the optimal strategy selected evaluate options and model sensitivities/scenarios to stress from each work stream, including, but not limited to: test the various options. • Capital markets solutions • Solvency opinions Companies must act quickly – they must Explore • Informal restructuring and formal filings thoroughly contemplate available strategic options Perform exploratory market soundings to validate model • Implementing arrangements, and inputs and assumptions. Determine if a formal or informal • Other performance enhancement initiatives. and develop an executable plan to send a clear and restructuring initiative is required and help management positive signal to the market. understand the implications and chain of events which come into play with each alternative. Provide management with a description of the pros and cons of alternate options in the event of a restructuring event and how each stakeholder group may be affected.

12 The Canadian convertible debentures market How to avoid the death spiral of converts 13 To learn more, contact:

Pierre Laporte Partner Deloitte Restructuring Inc. +1 514-393-7372 [email protected]

Paul Casey Partner Deloitte Restructuring Inc. +1 416-775-7172 [email protected]

Robert C. Olsen Partner Financial Advisory Services +1 416-601-5900 [email protected]

Andrew Luetchford Partner Deloitte Inc. +1 416-601-5277 [email protected]

www.deloitte.ca

Deloitte, one of Canada’s leading firms, provides , , consulting, and financial advisory services. Deloitte LLP, an Ontario , is the Canadian member firm of Deloitte Touche Tohmatsu Limited. Deloitte operates in Quebec as Deloitte s.e.n.c.r.l., a Quebec limited liability partnership.

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