Opportunities for U.S. Private Equity in Canada’s Energy Sector
March 14, 2016
The Canadian energy sector represents a unique investment opportunity for private equity investors seeking to invest in, or acquire outright, established energy assets at a discount to historical prices. The ability to capitalize on the discounted debt of oil and gas companies in a low-risk jurisdiction like Canada has never been more attractive.
One of the many factors that make investing in Canadian oil and gas companies so appealing is the steep drop in international oil prices over the past 18 months. They are currently at US$30-$40/barrel and are not expected to recover in the short term.
Another factor is a sustained decline of the Canadian dollar, which depreciated more than 16 per cent against the U.S. dollar in 2015.
Further, the effects of both the federal and Alberta provincial elections signalled a relative end to uncertainty surrounding domestic investment, tax and energy policy. This confirmed that Alberta will be largely maintaining its existing oil and gas royalty structure (following an extensive review concluded in January 2016) and refocused the federal government on the promotion of green energy initiatives.
Continued pressure on oil and gas companies to dispose of assets in order to rein in borrowing base levels is also playing a role.
The current economic forecast has resulted in an attractive environment for distressed investment and, as a result, many private equity and pension funds are currently considering Canadian energy opportunities through various investment vehicles.
PRIVATE EQUITY DEAL EXAMPLES AND NEW OPPORTUNITIES
A number of large publicly announced transactions were completed in the Canadian energy sector in the past 18 months, including a series of significant asset sales by Encana Corporation to consortiums of financial buyers led by KKR & Co. L.P., Apollo Global Management and Canada Pension Plan Investment Board. Similarly, various public issuers have completed debt and equity offerings, including those by Connacher Oil and Gas (which converted C$1-billion of its bonds into 28 million shares and issued another C$35-million in new second-lien convertible notes) and Laricina Energy (which made a pro rata offering of approximately C$84-million in common shares and repaid in cash C$30-million of principal on outstanding senior secured notes pursuant to a settlement agreement with Canada Pension Plan Credit).
According to Sayer Energy Advisors, as of February 2016, 22 companies in the Canadian oil patch had publicly announced an intention to sell themselves, with an additional 41 companies having announced an intention to sell a material portion of their assets. It is unsurprising that BMO Capital Markets estimates that up to US$175-billion of private equity and pension funds are currently considering investment into Canadian energy opportunities.
Many analysts predict that divestiture activity by struggling Canadian energy companies is likely to focus on midstream assets, such as pipelines, storage and processing facilities. These assets are of particular interest to private equity investors as banks will provide acquisition financing secured by them, allowing a fund to sufficiently leverage its equity investment.
There are numerous ways for financial investors to access the value available in the current Canadian market, including:
- “Loan-to-own” strategies, discussed in detail below
- Public acquisitions of TSX-listed issuers by way of a take-over bid (tender offer)amalgamation (merger) or court-supervised plan of arrangement
- Private acquisitions by way of a share or asset purchase
- Joint ventures with existing projects
- Minority equity investments, including in TSX-listed issuers by way of private placement
- New debt investments, as either a senior or mezzanine lender, alone or in combination with an equity investment
STRUCTURING THE PRIVATE EQUITY ACQUISITION
Financial buyers new to the Canadian market will find many similarities to U.S. merger and acquisition transactions, but also some differences. Of fundamental importance will be the correct structuring of the deal to ensure that both repatriation of earnings during the life of the investment and exit will be efficient.
Pushdown of Acquisition Financing
A U.S. private equity fund will almost always use a Canadian acquisition vehicle (Canco) to buy a target. Rather than effecting the acquisition by a merger, as is common in Delaware, the Canco will first buy the shares of the target and then the two entities will amalgamate (merge). Canco will typically be the borrower under any acquisition financing, so the amalgamation effectively “pushes down” the acquisition financing into the Canadian target, thereby allowing the interest expense to be deducted against its earnings (since, unlike in the U.S., Canada does not permit tax consolidation within a corporate group).
Financing and Cash Repatriation
The Canadian business may be financed by third-party and/or internal debt. Canada generally does not impose non-resident withholding tax on payments of ordinary (i.e., “non-participating”) interest to arm’s-length lenders. The statutory rate on payments of interest to non-arm’s-length lenders is 25 per cent, typically reduced to 10 per cent under most treaties (and zero per cent under the Canada-U.S. tax treaty).
If the Canadian business is to be financed with internal debt, consideration must be given to the 1.5-to-1 debt-to-equity ratio under Canada’s “thin capitalization” rules, which, if applicable, denies interest deductibility in excess of the ratio, with any excess treated as a dividend subject to withholding tax.
Once the acquired business begins to produce income, there may be a desire to repatriate funds from Canada. Dividends paid by a Canadian company to its non-resident shareholders are subject to non-resident withholding tax at the statutory rate of 25 per cent, although the Canada-U.S. tax treaty (or another treaty applicable to fund investors) typically reduces the rate to 15 per cent (in certain circumstances a five per cent rate may be available, and a zero per cent rate generally applies for U.S. tax-exempt investors). The Canadian company may also make returns of available “paid-up capital,” generally allowing withholding-tax-free distributions up to the amount of the equity invested by the U.S. private equity fund on acquisition, if structured properly.
Canada generally taxes non-residents on the disposition of equity that derives more than 50 per cent of its value from Canadian real property (including resource property). The “section 116” compliance regime will generally impose a 25 per cent withholding obligation on a purchaser unless the vendor has obtained a clearance certificate from the Canada Revenue Agency. Proper planning is needed at the outset of an investment in Canadian energy property to ensure that a future exit will be as tax efficient as possible.
Planning for Management Equity
Private equity funds will often establish equity incentive plans for management, including by granting profits interests at the fund level. This is not generally efficient for management of a Canadian company, since the Canada Revenue Agency is likely to treat the granting of the profits interest, for no consideration, as a taxable employment benefit to the recipient at the time of grant. There are other management incentives that can be utilized, such as stock options in the Canadian company.
WHEN THE TARGET IS DISTRESSED
As noted above, an increasingly attractive method of acquiring the assets of a Canadian oil and gas company is through the purchase of the target’s distressed debt securities, often referred to as a “loan-to-own” structure. Investors buy up the senior debt in a target’s capital structure, relying on the covenants and liquidation priorities to mitigate the downside risk of their investment.
In Canada, the acquisition of an insolvent target typically requires a court process to convey its assets where they are worth less than the target’s liabilities. Prior to the conveyance, a sale process must be conducted to determine the most advantageous transaction for the target and its creditors.
The Companies’ Creditors Arrangement Act (CCAA) is the principal statute in Canada for reorganizations and sales of large insolvent companies, although sales under the Bankruptcy and Insolvency Act and in receivership do also occur. The CCAA sale process has been influenced by parallel sales processes under the U.S. Bankruptcy Code, and the two statutes share a number of similar features.
A distressed company will often enter into a purchase agreement with a “stalking horse” bidder. That agreement is then shopped around to other prospective purchasers who are invited to top the stalking-horse offer. In other situations, a distressed company will go “naked” into a court-approved sale process (with no stalking horse). An investor that has purchased distressed debt, often for cents on the dollar, is entitled to bid the full value of that debt (a credit bid) for the assets being marketed. While some U.S. courts have capped the amount of distressed debt eligible to be bid, Canadian courts typically allow the debtholder to bid the full amount of its claim as long as the sales process is determined to be fair.
The purchase of distressed assets from an insolvent company comes with a number of unique context-specific risk factors to consider, including:
- The importance of ensuring an arm’s-length relationship between the potential buyer and the target to avoid a challenge that the sale is really a fraudulent preference or conveyance
- The possibility of due diligence complexities
- The risk of a trustee in bankruptcy disclaiming a signed purchase agreement that has not yet closed
Investors may be able to minimize some of these risks by purchasing representation and warranty (R&W) insurance. R&W insurance will indemnify a purchaser for unforeseen losses suffered as a result of an insolvent seller’s breach of the purchase agreement. Without the insurance, any claim for breach against the insolvent seller itself may be of limited value.
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