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Endeavour Financial Tops in Debt Financing

Endeavour Financial Corporation (TSX:EDV) announced on May 6th that it had completed three debt transactions on behalf of client Pacific Rubiales Energy Corp.(TSX:PRE), a Canadian-based oil and gas producer with operations primarily in Colombia. The transactions, totaling US$430 million, shed light on some of the developments in resource financing that have arisen since the onset of the global economic recession.

The first issue illuminated by this deal is the fact that debt for resource projects is emerging in a big way since disappearing completely in October 2008, and has replaced equity as a preferred method of financing major projects. Not that debt hasn't always been the preferred structure of "last mile" financings, but the debt aspect is starting to occur further back down the development cycle, as well as displacing completely the equity component of traditional debt/equity combinations.

The reasons for this are manifold.

First, debt financing is typically secured by the underlying asset and any cash flow that might be extant. So bond (debt) holders are first in line in the event of cataclysmic event that derails the development of the project. Their risk is the difference in price between what the assets in their current state will fetch at auction and the price of their financing.

Secondly, debt comes with interest payments, so the risk is diminished by the payment incrementally of principle in combination with interest, thereby incrementally retiring risk as the debt matures.

Those are the two primary drivers that attract investors to debt deals fundamentally over equity.

The aversion towards equity financings is indicative of the perceived environment of the global economic landscape as well. Whereas an equity investor gets to participate in the cash flowing from any given asset in perpetuity, or as long as they own their piece of the pie, a debt investor's exposure is limited to a finite time horizon, thereby quantifying in advance the performance of the investment over a known time segment. Conservative money prefers a definite known payout over an unknown potential payout, even though the latter is potentially exponentially more valuable over time.

Prior to the recession and the financial market disasters that precipitated it, it was harder to raise big blocks of capital for resource projects because a lot of the money now flowing towards these financings was previously preoccupied with chasing money market transactions in private equity and in derivatives related to credit and real estate.

The financial crisis has effectively closed the door on such derivative transactions, and government issued debt is not paying very well either. So with the attractive interest rates available from such debt transactions as the one by Endeavour for Pacific Rubiales, investors are able to realize substantially better yield than they could from these traditional safe haven, AAA-rated asset classes, which have now been revealed to be less than investment grade.

But what about the company accepting the financing? Is a debt deal better than an equity deal for such major financing components?

In most cases, the company's sole determination on that question is derived from the Weighted Average Cost of Capital (WACC) associated with either financing method. The weighted average cost of capital is the rate that a company is expected to pay to finance its assets.

Whereas equity financings can provide better WACC metrics when a company's share price is high relative to its peers, book value, and/or price/earnings ratios etc., the company can finance itself far less dilutively because it issues fewer shares for larger increments of capital.

But when companies see there valuations crumble, such as in the case of the last 18 months in the natural resource sector, raising capital through equity becomes extremely dilutive, and limits the potential value of its shares in the future. Plus, in the current market where safe haven asset classes are paying less than the rate of inflation, and where inflation is expected, or at least, is potentially so, debt becomes more attractive to both investor and companies requiring capital.

In the uncertain economic environment, and with resource company valuations still low due to underlying commodity price weakness, debt transactions such as those structured by Endeavour Financial will be the most important financing instrument to get resources into production. And with global unemployment soaring, governments will be seeking ways to bring production assets on stream sooner rather than later.

Endeavour today announced third quarter earnings of US$0.09 per share on revenue of $8.8 million, marking a return to positive net income.

SOURCE: http://www.midasletter.com/news/09051206_Endeavour-Financial-tops-in-debt-financing.php


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