Much has been made about the strength of the Canadian banking system relative to its U.S. counterpart during the past recession, and while the U.S. system continues to lag behind its northern counterpart in terms of bank balance-sheet quality, the U.S. lending market has thawed materially in terms of availability.
According to Thomson Reuters, U.S. middle market leveraged loan volume for 2011's second quarter registered a 52% year-over-year gain and was up 15% over 2011's first quarter. Further, the U.S. high-yield bond issuance market registered its highest levels ever in May 2011.
Based on our recent experience, U.S. banks are willing to underwrite as much as four to five times the latest 12 months (LTM) earnings before interest, taxes, depreciation and amortization (EBITDA) for transactions involving companies with more than US$10 million in trailing operational cash flow.
Currently, Standard & Poor's reports that the average debt-to-EBITDA for mid-market loans in the U.S. stands at 4.6 times, up from 3.8 times a year ago. Further, with the availability of mezzanine debt in the U.S., total transaction debt can reach as high as six times LTM EBITDA.
With most U.S.-based transactions taking place at less than eight times LTM EBITDA, doing deals requires a very limited equity check from potential buyers; in some cases deals can be fully debt-financed.
In contrast to the above, Canadian banks tend to limit deal leverage to between 2.5 and 3.5 times LTM, reflecting their conservative bias. Further, there is a general lack of mezzanine debt in Canada, especially relative to the U.S., and therefore total transaction debt is often capped at four times.
Junior debt in Canada tends to take the form of second lien notes, requiring a collateral backstop, where mezzanine debt is generally, by definition, not collateralized. Notably, we have never seen an unsecured piece of junior paper from a Canadian issuer.
Additionally, Canadian corporate lending rates, in our experience, generally exceed U.S. lending rates by 50 to 150 basis points (bps) for good quality corporate credits and by even wider margins as credit quality declines.
This again reflects the more conservative risk-appetite of Canadian lending institutions. Our experience with junior debt in Canada has often yielded spreads of 300 to 500 bps over term sheets from U.S.-based junior lenders, due primarily to a lack of a competitive market.
While the Canadian prime rate is cheaper than its U.S. counterpart, the spread is only 25 bps. That makes the cost of debt capital superior in the U.S. when one considers the higher pricing structure employed by Canadian banks.
Notably, U.S. and Canadian 10-year government bonds are currently trading at the same yield, according to the Financial Times. That suggests the spread is owed entirely due to risk profile.
To fully realize this "arbitrage," it's best if U.S.-dollar-dominated debt can be serviced and repatriated using cash flows generated in Canada. While a buyer can benefit from the greater leverage opportunities in the U.S. in isolation, using cash flows generated in Canada dollars for interest and principal payments provides the added benefit of the favourable loonie exchange rate.
Currently, the loonie/U.S. dollar exchange rate is 1.05, which reflects the continuing rise of the Canadian dollar. When one takes the exchange rate into account, U.S.-based leverage alternatives appear even more cost effective.
