The Canadian power and utilities industry is not traditionally known for groundbreaking wheeling and dealing. But in the six months that ended February 15, 2016, the sector has witnessed the acquisition of three U.S. utilities by Canadian companies for a total US$24 billion.
These transformational deals have come with relatively large price tags for the acquirers and have sparked the need for some innovative financing.
Two of the deals this year have mimicked a strategy pioneered by Fortis when it purchased UNS Energy of Arizona in December 2013. That was an all-cash deal worth US$4.3 billion, including US$1.8 billion in debt.
It marked the first time that a company issued convertible debt for a deal using installment receipts.
What are installment receipts?
Installment receipts are a form of subscription receipt. The latter is used to raise funds for proposed acquisitions. Investors put money down up front and usually accrue dividends until the deal closes, at which point the receipts are converted into common shares in the combined company (or, as in the Fortis deal, the receipts are exchanged for convertible debentures).
If the deal fails, the funds are returned with interest. This is attractive to the company because, if the deal falls through, it is not sitting on idle equity.
Investors also like subscription receipts because they know why they are putting up the money, and won’t be stuck with a deal they never approved.
Installment receipts are similar, except that investors put the money down in parts (usually half at the start and half on the acquisition closing). Installment receipts were more popular two decades ago, and then fell out of use. Why? Some notable deals ran into trouble in the late 1990s, when investors tried to walk away because the shares had traded down significantly in value and they didn’t want to lose more money by making the second payment.
Those deals that turned bad, however, were mostly in the resource sectors. In one example, the TSX actually suspended trading in the installment receipts of Boliden Ltd. in 1998 because they had negative value, trading at less than the amount of the second installment still due.
The deals in the power industry today are much different, with stable cash flows in the sector unlikely to experience anything close to a 50% haircut.
Leverage can triple returns
Much like the way installment receipts for common shares accrue full dividends, the recent deals in the power space also accrue full interest payments for future debenture holders.
The Fortis deal featured convertible debentures with a 4% coupon. But since only one-third of the funds were put down to start, investors received an effective 12% interest rate until the deal closed (a span of almost 10 months). Two recent deals by Emera Inc. and Algonquin Power have been structured in similar fashion.
In September 2015, Emera announced its intention to acquire TECO Energy, an electricity and natural gas provider in Florida and New Mexico, for total consideration of US$10.4 billion. Like Fortis, Emera offered a 4% coupon with an effective 12% yield, and is also anticipating a 10-month closing period.
In February 2016, Algonquin Power unveiled its proposed acquisition of Empire District, an electric and natural gas utility with 217,000 customers in four U.S. states. Algonquin’s debentures offer a 5% coupon, and an effective 15% interest rate over an expected 12-month closing period.
Measuring and comparing deals
As with any common share or convertible debt deal, it’s worth noting the discount on the deal or conversion price relative to the recent share price.
When Fortis did its deal at the end of 2013, the conversion price on the debentures marked a 2% discount to the recent share price. On Emera’s deal, the company offered a conversion price at a 5% discount. And most recently with Algonquin, shareholders took a 9% hit when the shares traded down to the conversion price. There can be many reasons for issuing capital at a discount, but with each successive deal, the target company became larger relative to the acquirer. With large or transformational deals, companies often need to offer bigger discounts to secure adequate financing for an acquisition.
Too good to be true?
When you’re offered triple returns for seemingly no reason, the deal could be too good to be true. Companies claim they don’t need the cash before the deals close, but that’s no reason to throw it around. In short, the effective yield is an incentive for investors, and the company needs to secure the financing in advance somehow, whether it’s by paying dividends on new common shares, or fees and interest on a bridge loan.
The large risk to investors is the potential for the share price to go south, leaving debenture-holders with a loss greater than the effective yield. One possibility is to hedge the investment by shorting the common stock and trying to lock in the gain from the effective yield. While there are costs to shorting shares, they may be worthwhile to incur.
Of course, nothing is guaranteed. With arbitrage strategies, there is risk that the underlying securities do not trade as expected in relation to each other. This can be caused by different reasons, including liquidity. Insufficient liquidity in the convertible bonds—or, in this case, the installment receipts—might cause the arbitrage profit to deteriorate or disappear if something negatively impacts all the company’s securities. So those effective returns might be too good to be true after all.