The Canadian Advantage
Even public companies in the US, accustomed to lower-cost alternatives, are starting to see the benefits of the “bought deal” mechanism for issuing equity
AFTER THREE DECADES as the undisputed heavyweight champ of Canadian equity markets, the bought deal may be attracting challengers, but none of them are true contenders.
Bought deals — in which underwriters buy the entire issuance from the client company before it’s marketed to the public — have been very good business in Canada, accounting for some 90 per cent of non-IPO (initial public offering) Canadian equity issuances, year in and year out.
With quarterly bought-deal totals regularly reaching several billion dollars, Canadian investment banks as a group earn hundreds of millions per quarter. The companies issuing the equity get big no-risk capital injections — which can be dedicated to stated uses — and investors have proven ready to consistently buy up at least the name-plate offering, frequently extending to over-allotments of shares that further reward issuers and underwriters.
Since its introduction by Gordon Capital in the mid-1980s, experts say, the all-powerful bought deal has kept both alternative investment structures and competing foreign investment banks largely at bay in the Canadian capital markets. Now, however, a few inventive invaders are testing other investment structures.
The key driver of the bought deal is speed, says Stephen Pincus, a securities lawyer with Goodmans LLP in Toronto. An issuer can often have cash in hand for the full amount of the deal, plus any over-allotment, within about 15 business days of signing a bought-deal letter with an investment bank or syndicate. In the US, the same bought-deal process is only available to very large issuers, and used relatively sparingly, while a conventionally marketed deal can take three to six months.
National stereotypes to the contrary, Canadian underwriters and investors have embraced the risks of bought deals, while their US counterparts have not, says Calgary securities lawyer David Phillips of Bennett Jones LLP. “Bought deals are the standard way of raising capital in Canada and have been for over 30 years,” Phillips says. “You can do bought deals in the United States — it’s just not ‘the way things are done’ down there.” This, he says, has had the effect of largely keeping US underwriters out of the Canadian market. Foreign banks sometimes participate in a bought deal, but invariably with a Canadian bank as lead underwriter.
Pincus says the bought deal is an enormous advantage for a Canadian company planning an acquisition. “It allows the buyer to have a cheque in hand,” he says. “It absolutely makes Canadian companies more competitive from an available-capital point of view,” Pincus says. “It’s the special sauce of the Canadian market. It’s often called the ‘Canadian advantage.’”
The other great virtue of the bought deal, Pincus says, is that it locks in a guaranteed return for the issuer because underwriters buy the entire issuance from the client company at an agreed price before taking it to market. Unlike a conventional marketed deal, the issuer doesn’t have to worry that short-sellers will drive down the market price. That risk is passed to the underwriter.
The agreed price for a bought deal usually entails a discount of between one and four per cent off the current market price of company stock, which insulates the underwriting banks from the risk of taking the new issuance to market. That discount is then passed on to the market as a purchase incentive, while underwriters receive a hefty three- to seven-per-cent fee for selling the issuance into the market.
“Underwriters have lost money, but that’s very rare,” Pincus says. They regularly sell out the issuance to institutional investors and retail brokerages within hours or days of announcing the offering. On a hypothetical $1-billion bought deal, with a typical four-per-cent fee, underwriters stand to earn some $40 million in two to three weeks, assuming they sell out the issuance at full price. Phillips notes that TransCanada Corp. paid a $143-million fee (3.25 per cent) to underwriters last year in a Canadian-record $4.4-billion bought deal, which helped fund its $13-billion purchase of Columbia Pipeline Group.
Sampling some 5,000 non-IPO issuances in Canada from January 2014 to December 2016, Goodmans estimates that 90 per cent of offerings by previously listed companies are now executed as bought deals. Pincus says some of those deals are done by small- to mid-size foreign-domiciled companies that are drawn to issue equity in Canada due to the relative ease and speed of the Canadian bought-deal process, which he chalks up to regulatory responsiveness and the creativity of Canadian investment banks.
Larger Canadian issuers are typically ready to do a bought deal whenever an acquisition opportunity or other business situation makes it attractive, he says. Every registered Canadian company is required to file an annual information form, and this becomes the basis for drafting a new short-form prospectus, to which any recent material events are added.
The issuing company then seeks commitment from one or more underwriters (investment banks) in the form of a bought-deal letter that sets out terms of the agreement. The letter is legally binding on the underwriters (Ontario Superior Court, Stetson v. Stifel Nicolaus), requiring them to buy out the entire issue at the agreed price. It specifies the level of any discount below market at which underwriters will acquire the entire new share issue and sell it on, as well as the fees to be earned for marketing the issue.
The issuer and underwriters sign the agreement and, on the same day, issue a press release announcing the issue of new shares, usually mid-week and after the close of trading. The release also specifies the intended use of proceeds, which allows prospective investors to judge whether the net effect will be accretive. This becomes day one. The deal is then public and underwriters are allowed to “pre-market” shares to institutional investors, without waiting for a preliminary short-form prospectus to be filed with regulators and approved. This pre-marketing represents a special bought-deal exemption from insider trading rules that otherwise require prospectus-level disclosure before shares can be sold to the public.
The issuer and its lawyers then have up to four days to file a preliminary prospectus, bringing the process to day five (or less if they file earlier). An approved final prospectus is usually filed by around day 10. This allows underwriters to close deals contained in expressions of interest secured from institutional investors in the pre-marketing period. If the issue is selling well, the issuer and underwriters can agree to an over-allotment, in which additional shares are sold on the same terms as the original bought-deal agreement, but with the requirement that a new press release be issued to inform the market. In most cases, Pincus says, the entire process is wrapped up and the issue is sold out within two to three weeks.
There’s nothing legally binding about the expression of interest by institutional investors, Phillips says, “but for all intents and purposes, it’s a deal.” He concedes that an investor could renege. “But guess what, they’re not going to get the call next time.” Since bought deals are the lion’s share of the market, expressions of interest are always honoured.
Now, however, the dominion of the bought deal is being questioned in certain quarters. Desmond Lee, with Osler, Hoskin & Harcourt LLP, says there have been recent instances of foreign underwriters seeking to make inroads for alternative deal structures in Canada. He’s not convinced usurpers have so far found a winning formula — but efforts are being made.
Last September, for example, Credit Suisse Securities and JPMorgan raised $1 billion for Encana Corp. with a modified block trade done on a fee of 1.8 per cent — or less than half the standard fee for a bought deal. But Phillips agrees there are many reasons why this structure appears unlikely to make major waves in Canada. “It was really a US offering,” Phillips says. “It was priced in US dollars and shares were delivered through … a US clearing agency. It was filed in the US with the SEC, as well as in Canada.” And proceeds were largely dedicated to Encana’s US exploration and production activities.
The deal was announced on September 19. A preliminary bulleted prospectus supplement was then filed and the offering was marketed the same night. “The low underwriting fee was presumably due to the underwriters being able to market the offering before pricing it and committing to buy it — all consistent with US underwriters’ discomfort with the bought-deal structure and attendant risk,” Phillips says, pointing out that the Encana arrangement was dependent on too many peculiar circumstances — a well-known Canadian issuer, listed on the NYSE, with a sufficiently large US investor following — all of which ensure it’s unlikely to be replicated on a regular basis.
Some other alternative structures have been tried, including selling an entire issue directly to institutional investors, without the involvement of underwriters, Phillips notes. But, so far, none has assumed the profile of a powerful new trend.
Lee says the trend may actually be tilting in the opposite direction. “I don’t see the bought deal in Canada going away anytime soon,” he says. “The simplicity, predictability and low execution risk of the bought deal will continue to make it the predominant means of carrying out an equity offering in Canada. If anything, we see the bought deal becoming more popular in the US market.”