Opportunity in an Uncertain World


By Sean Morrison
Managing Partner, Maxam Opportunities Fund LP

Introduction by David Sung, CFP, CLU, RHU
President, Nicola Wealth Management Ltd.

The current market environment has actually presented many solid investment opportunities, but they still require due diligence and well-structured business deals. As part of our firm’s belief in seeking out valuable opportunities and working with credible partners, we recently offered our clients the ability to participate in the new Maxam Opportunities Fund LP.

Maxam is managed by Sean Morrison and Johnny Ciampi. Sean, whom I have known for many years, has written the following piece to introduce the fund and its philosophy to our clients. Prior to forming Maxam, Sean was a partner at the Vancouver-based investment banking firm,  Capital West Partners. For over 12 years, Sean advised companies across Canada with respect to capital raising (senior debt, subordinated debt and private equity), IPOs, debt restructurings, asset sales, acquisitions, valuations and fairness opinions. His clients included companies such as The Keg, Lululemon, Aritzia, Robeez, Sterling Shoes and Sierra Systems.

One of Nicola Wealth Management’s primary goals is to find bright, knowledgeable, and experienced business partners with whom we can be sure our clients’ best interests are being served. With that, it is my pleasure to introduce Sean Morrison as he offers Maxam’s view on the market, their investment philosophy, and the opportunities available.
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Organizations with cash will have many opportunities, whereas organizations that need new capital (debt or equity) may be forced to sell assets at distressed prices or accept capital on terms much more restrictive and expensive than before.

The best and most public example of the ‘cash is king’ mantra is Warren Buffet’s Berkshire Hathaway (Berkshire). Berkshire was sitting on $40-billion of cash. As a large investor in Berkshire stated, 

“What Buffet has been waiting for, for years, is finally happening: a period of sufficient market distress where he can negotiate terrific financial terms for Berkshire.”

A perfect example is Berkshire’s combined US$8-billion investment in two of the world’s leading companies – $5-billion in Goldman Sachs and $3-billion in General Electric.

Each of these companies was desperate for capital to shore up liquidity on their balance sheets and Berkshire was one of the few investors that could move quickly, “write the cheque,” and instill confidence.

In each of these deals, Berkshire purchased preferred shares with a 10% preferred dividend – twice the dividend rate of most investors. By investing in preferred shares, Berkshire’s investment in each company ranks ahead of all the common share equity in the business – in Goldman Sachs’ case US$50-billion of equity and in GE’s case US$200-billion of equity.

In addition to the purchase of preferred shares, Berkshire was issued 5-year warrants to purchase US$8-billion of common shares at below the current market price.

In both cases, the shares of the companies were trading at 52-week lows and approximately 50% of their 52-week highs. Therefore, he was investing at a distressed price.

Through structuring, Berkshire was able to protect its downside (preferred shares), earn a high current yield (10% dividend rate) and participate significantly in the potential upside (5-year, in-the-money warrants).

Neither of these deals is without risk, but the structure of the investment provides Berkshire with a very attractive risk-adjusted expected return.

As Warren Buffet stated,

“Frankly, these markets are offering opportunities that weren’t available six months or a year ago.”

Maxam Opportunities Fund LP
 

The Maxam Opportunities Fund raised over $100 million in early July. The rationale for Maxam was developed in December 2007, a few months after the initial shocks of the credit crisis were being felt.

The rationale was simple: the credit crunch would eventually impact equity values negatively, and good companies that could normally access the debt and public equity markets to fund acquisitions, growth opportunities and working capital, would need to seek alternative sources of capital.

We certainly had no idea that the credit crunch would almost topple the entire financial system!

Structure

Most public market-focused funds are structured like a mutual fund, whereby they raise capital and provide investors with liquidity on a monthly basis. The major issue with this type of fund is that the vast majority of capital is immediately invested.

Maxam is structured like a private equity fund, whereby the capital is committed, allowing Maxam’s fund managers time to patiently deploy the capital over a number of years (in our case, four years).

 Given the uncertainty in the capital markets, we did not want to be pressured to deploy the capital quickly. Furthermore, we felt that it would take 12-18 months for the full impact of the credit crisis to affect the market and for companies to feel the repercussions of reduced access to credit.

Market Insight

Over the last three months, we have been actively promoting our fund to investment bankers, equity capital markets traders, institutional brokers, other investment funds, accountants and lawyers. The purpose was to introduce ourselves and the Maxam Opportunities Fund to financial intermediaries advising most of Canada’s mid-market public companies.

The market uncertainty combined with the size and mandate of the fund has allowed us to meet with over 50 groups across Canada. We have met with many very senior executives, including the Vice Chairman and Head of Investment Banking for two of the five major Canadian banks.

Based on these meetings and relationships, we have gained valuable insight into their professional views on the current state of the financial markets, as well as the potential opportunities.

Market Reaction

We have received an overwhelmingly positive reaction to the relevance of Maxam, as virtually all financial intermediaries are convinced that it will be harder for mid-market companies to raise capital over the next few years.

However, many of the investment bankers are not happy that our fund is now “relevant” as it sends a strong signal that the days of doing bought deals and unsecured convertible debentures (easy deals) are over. One investment banker actually stated he “hated debt deals.” The reason he hates them is that structured lenders (like Maxam) want to perform due diligence on the company and negotiate stringent terms, whereas for bought deals it’s simply a matter of setting a price and making several phone calls. In summary, structured deals take longer, require more effort and there’s a much greater chance that a deal will not close.

Leverage, Liquidity and Redemptions

A significant portion of the problems in the capital markets is directly related to the excessive amount of leverage being deployed in businesses and by hedge funds.

Highly leveraged businesses needing to refinance their debt are getting crushed in the capital markets. There is a genuine fear in the markets that even strong companies will have trouble refinancing their debt. Even deals with committed financings (Teck’s acquisition of Fording and Ontario Teachers acquisition of BCE) have traded at significant discounts as the market thinks there’s a high level of risk as to whether the banks will actually fund their commitments.

Many hedge fund managers use large amounts of leverage to maximize their returns. When stock market prices move down dramatically, hedge funds get margin calls and banks start selling their shares. This forced sale of shares exacerbates the downward price in shares.

Poor monthly performance by mutual funds and hedge funds results in redemptions by investors. In order to fund redemptions, these funds must sell the shares they own – in most cases their better names, as those are the only ones they can actually sell. In extreme cases, really negative returns may result in the hedge fund winding itself up. In this case, they must liquidate all their investments.

The combination of leverage and redemptions has resulted in immense selling pressure, which is driving down share prices for all companies. This creates the opportunity, as many really good companies are selling at incredibly depressed valuations only because of the distress in the market.

Deal Flow

In the first three months of business, we’ve seen many opportunities.

The first transaction we completed was with a local company seeking capital to fund an acquisition. The company needed CAD$20-million of capital to fund a US$16-million acquisition and Maxam invested CAD$4-million as part of a syndicate. The company was debt-free and didn’t want to raise equity at depressed prices. The deal was structured as a 12-month senior secured bridge loan with an interest rate of 12% increasing to 15% plus five-year warrants. We were very comfortable with the assets securing the loan and felt that over the next five years there would be a reasonably good opportunity for the company’s equity to appreciate substantially, thereby making the warrants valuable.

The second transaction was to a private company that needed capital quickly to secure the right to acquire an asset. Maxam funded $3.5 million of a $12 million bridge loan. All of the capital was put into a lawyer’s trust account requiring Lender’s direction – it was never “at risk.” As compensation for putting up the capital, the lenders were issued shares equal to 5% of the company. In addition, the interest rate was 2% per month. Since our capital was never “at risk,” we thought the project had huge equity upside, and with the cash interest rate at 2% per month, we were prepared to move very quickly to put our capital to work. This bridge loan was since repaid in November 2008.

We have seen a lot of resource deals – junior mining companies that have had access to the public markets over the past five years that have recently been cut off. Several of these companies had advanced projects to the point where they needed one more round of financing to complete their project. We have not pursued any of these projects as we have been unable to get comfortable with the underlying mining asset as security.

We have also seen quite a few real estate deals – development projects that require additional capital to fund cost overruns, development projects that are going into CCAA or are already in receivership that require debt or-in-possession (“DIP”) financing and small cap Canadian REITs that currently have no access to capital to fund acquisitions. We have not pursued any of the cost overrun projects, but have actively pursued the DIP opportunities. We like the DIP opportunities as the new money going into a project ranks ahead of all other debt, including the senior debt. The new money is typically used to complete the project and all sales proceeds go to first pay off the DIP lender, making most of these types of financings very low risk. DIP lenders typically have to move quickly and are able to charge high commitment fees and high rates of interest. We have looked at several REIT opportunities. We like the relatively low senior loan-to-value rates, given our new money would be second-secured and rank ahead of the unsecured convertible debentures and equity. However, we have decided to take a wait-and-see approach, as refinancing and increased cap rates become a major risk to their business.

Patience

As can be expected, many of the companies seeking capital in the early stages of a full credit contraction are the weakest companies with poor balance sheets and poor quality assets. Many of the companies we are seeing are in trouble and quite frankly, there’s not much hope for them.

We expect that a lot of companies, like investors, are simply in shock seeing what is happening in the capital markets. Many were simply hoping for a quick recovery – that doesn’t look like it’s going to happen. We believe this major contraction in credit will take several years to work its way through the system and that there will be many unique opportunities presented to those with cash!