Canada: Canadian Common Share IPOs: A New Path To Liquidity For U.S. Businesses

On May 17, 2007, Northstar Healthcare Inc. completed the first Canadian initial public offering of high dividend common shares by a U.S. business. Listed on the Toronto Stock Exchange, Northstar was formed to indirectly acquire and/or manage ambulatory surgery centres in the United States, focusing initially on Houston and other metropolitan areas in Texas.

This offering generated tremendous interest from both retail and institutional investors. While high dividend common shares appeal to the yield-oriented investors that fuelled the growth of Canadian income funds since 2000, the common share structure also attracted institutions that were not active investors in income funds. With the growth of the income fund sector curtailed by proposed taxation and a wave of privatizations, high dividend common shares are in strong demand in Canada.

Private equity investors, owner-managers, and companies looking to monetize certain divisions may wish to consider a Canadian IPO as a means of selling all or part of a U.S. based business or portfolio of assets. This path to liquidity may be attractive for a number of reasons, including:

• Attractive Valuations: the demand for income generating equities among an aging population at a time of low interest rates, combined with a shortage of such securities in the Canadian capital markets, enable appropriate cash flow producing businesses and assets to achieve favorable valuations.

• Deal Flexibility: Canadian institutional and retail investors have been receptive to public issuers of broadly ranging sizes. While there are many successful larger cap issuers, smaller and mid-sized issuers are also able to attract market interest and ongoing research coverage in Canada.

• Speed of Execution: an initial public offering can often be completed more quickly in Canada than a similar offering in the United States.

• Ease of Ongoing Access to Capital: Canadian "bought deal" offerings permit issuers to return to the capital markets efficiently and quickly to fund future growth and acquisitions. Moreover, most of the risk of marketing a "brought deal" offering is shifted to the underwriters upon announcement of the transaction.

• Monetization of Retained Interest: while sponsors are not necessarily required to retain an ongoing interest in the business after a Canadian IPO, if there is a retained interest the "bought deal" mechanism often enables sponsors to successfully and efficiently sell this down.

• Flexibility for Management: existing management can remain in place and be appropriately incentivized through a variety of compensation mechanisms, including a long term plan which allocates management a portion of cash flow, a stock option plan or a stock appreciation rights plan. If desired, sponsors/management can retain control of the business through their retained interest.

The high dividend common share structure may be used for cash flow producing businesses and assets in a wide variety of industries, ranging from real estate, energy, infrastructure and health care to services, manufacturing, distribution, retail, media and entertainment. The preferred candidates will have:

• a strong or dominant position in their respective markets;

• predictable and sustainable cash flows; and

• potential for growth.

While growth potential is certainly an advantage, a business with a low growth profile may achieve a better valuation in a Canadian high dividend common share IPO than under alternative exit scenarios. Other factors that may affect valuations include ongoing maintenance capital requirements and the depth and experience of the management team.

Canadian institutional and retail investors have in recent years demonstrated a healthy appetite for income generating equity securities. A number of demographic, economic and market factors - including an aging population, low interest rates and volatile equity markets in the wake of the bursting of the "dot-com bubble" – combined to stimulate this demand. As a result, the Canadian income fund sector grew from 52 income funds with an aggregate market capitalization of $20 billion in 2000 to approximately 254 income funds with an aggregate market capitalization of over $200 billion at the end of October 2006. Despite this growth, observers have suggested that (even adding high dividend issuers that are not income funds) the Canadian market for yield-oriented securities remains proportionally smaller than the U.S. market. Moreover, the available supply of yield-oriented securities in Canada has actually been contracting over the past few months.

On October 31, 2006, the Department of Finance (Canada) announced a proposal to tax publicly listed income funds and partnerships in the same manner as corporations. Previously, Canadian income funds had generally been able to distribute pre-tax cash to their investors. While income funds that were publicly listed on October 31, 2006 are not subject to this new tax until 2011 (provided they do not exceed certain equity growth limits intended to prevent their "undue expansion"), the tax proposals have effectively curtailed the continued growth of the Canadian income fund sector. Other than a few REITs, there have been no initial public offerings and no further conversions of Canadian public corporations to the income fund structure. At the same time, an increasing number of existing income funds have been acquired or privatized.

High dividend common shares are issued by a Canadian corporation (Canco) listed on the Toronto Stock Exchange. Canco is governed by corporate legislation and, therefore, not subject to the myriad of governance issues debated in recent years about income funds (which are trusts under Canadian law). Here is a simplified summary of the structure underlying Canco:

• Canco establishes a U.S. holding company (Holdco) and uses the net proceeds of the common share offering to acquire:

  • common shares of Holdco and
  • preferred securities of a U.S. subsidiary of Holdco (Subco).

• Holdco agrees to repurchase the Subco preferred securities from Canco in 10 to 15 years for their original issue price plus unpaid dividends.

• Subco uses the net proceeds to acquire an interest in the target business or assets.

This high dividend common share structure has been designed to maximize cash available for distribution to investors. Canco will pay periodic (monthly) dividends to its public investors; retained interest holders in the U.S. receive pro rata distributions from one of the underlying U.S. entities. Since the dividends to the public are typically paid in Canadian dollars, Canco will be expected to establish appropriate currency hedging arrangements.

The precise legal and tax structure of any particular IPO will depend on a number of factors, including:

• the nature of the underlying assets;

• the legal form of the target business;

• the interest, if any, that existing equity owners wish to retain in the target;

• the leverage of the target business, including how much debt is to be repaid or replaced;

• available depreciation and amortization; and

• future growth and acquisition strategy.

Under this structure, Canco should not be subject to a material amount of Canadian tax. This is because the dividends received by Canco on the Holdco common shares and Subco preferred securities should generally be considered to have been paid out of non-taxable exempt surplus or pre-acquisition surplus of the US entities (provided such distributions are generated from active business activities in the U.S.).

In the U.S., Holdco’s repurchase obligation in respect of the preferred shares of Subco is viewed as a financing transaction for U.S. federal tax income purposes. Accordingly, Subco’s distributions on these preferred securities should be treated as deductible interest payments, which will reduce or eliminate the U.S. federal income tax payable. The U.S. earnings stripping rules will limit the permitted aggregate interest deduction to approximately 50% of the target’s EBITDA.

Currently, distributions paid by Subco to Canco are subject to a 10% U.S. withholding tax imposed on interest payments. However, recently announced proposals to amend the Canada- U.S. tax treaty should result in this tax being phased out over the next three to four years. Dividends paid by Holdco to Canco will be subject to a 5% U.S. withholding tax to the extent paid out of the earnings and profits of U.S. Holdco (amounts in excess of earnings and profits will not be subject to withholding tax).

Distributions by Canco to its public investors will consist of common share dividends from a public Canadian corporation. For many investors, such distributions will be preferable on an after-tax basis to distributions from income funds and other similar investments. In particular:

• dividends paid to Canadian taxable investors will be eligible for the enhanced dividend tax credit;

• dividends paid to U.S. taxable investors will be subject to a 15% Canadian withholding tax (which amount will generally be creditable against the investor’s U.S. tax liability). In addition, such dividends should be "qualified dividends" for U.S. federal income tax purposes (taxed at 15% in the U.S.); and

• dividends paid to U.S. tax exempt investors will not be subject to Canadian withholding tax. Unlike Canadian income funds, there are no tax limits restricting non-resident ownership of high dividend common shares.

Once a determination has been made to explore a Canadian IPO, experienced underwriters and professional advisors can bring a high yield common share offering to market quickly and efficiently.

The process can be divided into three key phases:

• Phase One: preparing the structure and the preliminary prospectus;

• Phase Two: clearing the prospectus, completing the documentation and marketing the offering; and

• Phase Three: closing the offering and listing the shares.

While the length of the time required for Phase One may vary depending upon, among other things, the availability of information (including audited historical financial statements) and each of the factors mentioned above as affecting the structure, Phases Two and Three will generally take about five to seven weeks in total. During Phase Two, management and the underwriters will conduct "roadshows", meeting institutional and retail investors to market the offering. Concurrently, legal counsel will work on finalizing the transaction documentation and will work with the securities regulators to clear the prospectus. Immediately prior to filing the final prospectus, the price and size of the offering will be set. Phase Three is the period from filing the final prospectus and the signing of the underwriting agreement until closing of the offering.

The financial statements for the U.S. business may be prepared in accordance with U.S. generally accepted accounting principles as long as a note to the statements reconciles them to Canadian generally accepted accounting principles.

Conclusion

The increasing demand for income generating equities and the reduction in the number of publicly traded income funds suggests that the time is ripe for high dividend common share offerings in Canada. The efficiency and flexibility of the structure described above makes it particularly suited to cross-border IPOs.

Sponsors and managers may wish to explore this unique path toward selling all or part of a U.S. based business or portfolio of assets.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.