Fallout from the credit crunch

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Fallout from the credit crunch

• FEI Breakfast Seminar
• 25 November 2008

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Current state of the capital marketsManaging
funding requirements

• Joe HealeySenior Vice-PresidentErnst Young
  Orenda Corporate Finance Inc.
• 204 954-5568joe.a.healey_at_ca.ey.com

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Current market conditions subprime impact
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Where we are today

• 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
• 12 million, or 16 of US homeowners owe more than
  their homes are worth
• The IMF states that the global economy is headed
  for a recession in 2009 and estimates losses from
  the financial crisis to be 1.4 trillion
• The Fed, ECB, BoC and 3 other central banks cut
  benchmark rates on October 8, 2008 further cuts
  predicted

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Subprime related losses

• Financial institutions have experienced 966
  billion of asset write-downs and credit losses -
  708 billion are from over 100 of the worlds
  largest banks and securities firms

• Approximately 828 billion has been raised to
  meet these losses

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Subprimes impact on financial services

• Increasing defaults in the subprime market
  trickled into the financial services sector in
  late 2006 and early 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
• 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 have also had writedowns

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Funding scarcity

• The fallout of the credit crisis has been a
  scarcity of capital

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Funding scarcity (contd)

• In the secondary market, the average bid for
  multi-quote term loans is at its lowest point
  ever at 75.44
• 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

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Market stabilization money market indicators
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Market stabilization

• Markets have not yet stabilized and the credit
  markets are still tight
• Standard Poors predicts the credit crunch will
  end once four key economic and market variables
  are satisfied
• Real estate values stabilize or increase
• Rebound in home sales
• Easing of credit
• Decline in crude oil prices

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Market indicators

• Although LIBOR has come down significantly,
  credit conditions remain tight
• 3-month U.S. LIBOR is currently at levels not
  seen since October 2004

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Market indicators (contd)

• Prior to the credit crunch, the average spread
  between the 3-month U.S. LIBOR rate and the
  effective Federal funds rate was approximately 12
  basis points
• On October 10th, 3-month U.S. LIBOR peaked at
  4.82 representing a spread over the effective
  FFR of over 4.00

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Market indicators (contd)
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Market indicators (contd)

• Widening LIBOR-OIS spread

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Canadian perspective
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Canadian perspective
Source Bank of Canada
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Canadian perspective (contd)

• 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
• Gord Nixon - 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 - it needs to be determined which
  regulators will oversee financial companies in
  the U.S. and that process could last a year or
  more

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Availability of financing
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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
• 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

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Availability of financing (contd)

• Capital that may be made available for new
  funding has changed dramatically

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Availability of financing (contd)

• Debt/EBITDA multiples have decreased
  significantly in the large corporate market
  (EBITDA gt 50MM)
• Second lien loans have virtually disappeared

Average Debt Multiples of Large Corporate Loans
(EBITDA gt 50M)
Average Debt Multiples of Middle Market Loans
(EBITDA lt 50M)
Source Standard Poors, LPC
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What can get done?

• Asset based loans are increasingly attractive
• Loans gt 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 lt 3.0x
• Industry specific
• Sponsor makes deal easier
• Spreads in the range of 400 bps

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Treasury focus on short term liquidity
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Treasury focus on short term liquidity

• A portfolio approach to manage risk
• Understand the liquidity needs of the company
• Measurement/forecasting on a timely basis
• Actively manage investments or borrowings
• 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 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

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Financing today conclusion
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Financing today conclusion

• Be aware of the supply and demand constraints
• 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

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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

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Financial reporting implications of current
market conditions

• Mark Single
• Ernst Young LLP
• 204 933-0227
• mark.single_at_ca.ey.com

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Fair value in financial reporting - the debate

• Debate about merits of fair value in financial
  reporting
• Fair value measures necessarily reflect
  conditions at the balance sheet date, they are
  not forecasts of future market prices
• Investors want current fair value information and
  that transparency about fair values is important
• Implications going forward

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Recent market events accounting and reporting
considerations

• Valuation of investments
• Measuring fair values
• Evidence supporting fair value may not come from
  trading
• Valuation models should reflect assumptions that
  market participants would use in pricing an asset
  in a current transaction
• Inputs should be restricted to information
  available to market participants at the reporting
  date
• IAS 39 Amendments Reclassifications of
  financial assets
• Effective date is July 1, 2008, entities can make
  transfers as of that date provided this aligns
  with intent as of that date
• Extensive disclosure requirements when
  reclassifications are made

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Recent market events accounting and reporting
considerations

• Valuation of Investments (contd)
• CICA Amendments
• 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

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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
• 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

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Recent market events accounting and reporting
considerations

• Impairment of depreciable long-lived assets
• Impairment indicators are more likely to be
  prevalent, requiring assets to be evaluated for
  impairment
• Long-lived assets to be held and used are
  reviewed for impairment and tested for impairment
  whenever impairment indicators are present
• Due to the current economic environment, it may
  be more likely that impairment indicators exists
• Impairment must be considered at both interim and
  annual reporting dates
• When a long-lived asset is tested for
  recoverability, it may also be necessary to
  review depreciation and amortization estimates
  and methods

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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

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Recent market events accounting and reporting
considerations

• Income taxes
• Losses in recent years must be considered in
  evaluating deferred tax assets for realization
• Cumulative losses or expectations of cumulative
  losses generally indicate the need for valuation
  allowance
• Appropriate disclosures should be made to support
  either the absence or existence of the valuation
  allowance
• Liquidity concerns may cause companies to
  consider repatriation of earnings from foreign
  operations
• Consider accounting impact vs. cash flow impact

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Recent market events accounting and reporting
considerations

• Inventory
• Excess or obsolete inventories and lower of cost
  or market adjustments may be necessary
• Valuation issues associated with returns from
  merchants and leftover merchandise from the
  retail season
• Companies should disclose the manner in which
  lower of cost or market is determined
• Assess impact of idle plant capacity on overhead
  allocations

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Recent market events accounting and reporting
considerations

• Post retirement 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

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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
  impact of going concern assessment
• Share-based payments
• Accounting impacts of modifying, cancelling or
  replacing a share-based payment award
• Impacts of equity restructuring on share-based
  payment awards

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Recent market events accounting and reporting
considerations

• Revenue recognition
• Impact of any enhanced rights of return will
  require more attention on estimating returns
• Customer requests for extended payment terms
  could change the timing of revenue recognition
• 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

• Craig Roskos
• Partner, Tax Advisory Services
• Ernst Young LLP
• 204 933-0209
• craig.m.roskos_at_ca.ey.com

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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

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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

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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

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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
• Acquisition of debt at a discount
• Ensure undertaken in most tax efficient manner

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Closures

• Closure costs
• Maximize tax relief for costs e.g., which entity
  should incur the costs, when costs are incurred
• Losses
• Efficient utilization of losses and potential
  creation of losses as a result of closures
• Timing for merging of entities to optimize use of
  tax attributes
• Pensions
• Maximize tax relief for contributions

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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
• 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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