Like other corporations, Ontario's mostly municipally owned local distribution companies (LDCs) need capital to continue operating. Traditionally, this comes in the form of debt issuances or via the issuance of common shares.
Debt can be costly and only so much can be taken on before an LDC becomes over-leveraged and off-side its lender covenants. Common shares carry voting rights and their issuance results in the dilution of existing shareholders. For many reasons, LDC owners are loath to cede control over their LDCs to private investors, but most LDC owners are also keen to reduce their risk exposure in what is seen to be a less and less stable industry. The issue of private LDC ownership is politically fraught; there are very compelling tax reasons why municipalities wish to retain control; and, from a practical standpoint, the prospect of being diluted and/or losing voting control of the primary electricity provider in many Ontario communities is just too complex and uncertain for municipal political leaders to take decisive action.
This creates an attractive opportunity for institutional investors who are willing to take on higher levels of risk municipal governments normally prefer. It also creates an attractive opportunity for municipal governments who may want to get out of the electricity business and focus on the business of running cities and towns.
For institutional investors, the relatively stable revenue stream from Ontario’s larger LDCs is attractive. Large institutional investors, like pension fund investors, are particularly amenable to this sort of investment –even if there are clouds on the distant horizon. For Ontario, the solar tsunami is likely to be a gradual tide. There are years of stable, predictable LDC revenues remaining.
Investors will obviously seek control over their investment. Fortunately, the aspects of control which major institutional investors need relate primarily to fundamental issues - changes of control, major investments, non-arm’s length transactions, major debt undertakings, major projects, financial management changes and the like. Day-to-day operational control may not be of interest to many investors and can usually be left safely in the hands of management in the local office on Main Street.
The issuance of preferred shares can be structured in a way that fills the gap between common shares and debt described above, providing a lower cost method of raising capital or reducing municipal government ownership exposure without giving up too much control over the LDC.
How Do Preferred Shares Work?
Preferred shares are shares which typically carry ‘debt-like’ features such as fixed dividend rights, preferential treatment on insolvency, limited or non-existent voting rights and limited representation on the board of directors, but they come in many different forms and can be structured with a high degree of flexibility.
Here are the four main types of preferred share that we see actively used in the Canadian utility sector:
- The perpetual preferred share has no maturity date and pays a fixed dividend for as long as it remains outstanding. Due to its lengthy duration, the perpetual preferred share can be sensitive to interest rates going ‘under water’ when rates rise and can seem expensive to issuers when rates fall.
- The floating rate preferred share pays a dividend that “floats” with a certain reference rate, usually the prime rate, and pays a quarterly or annual dividend.
- The rate reset preferred share is currently the most used in Canada, making up about 60% of the preferred share market generally. This type of preferred share pays a fixed dividend rate until a specified “reset date” – typically around five years. On the reset date, if not called by the issuer then the holder usually has two options: a) keep the share at a new fixed dividend rate until the next reset date, where the new rate will reflect the interest rate environment at the time and is predetermined according to a spread above a comparable government bond; or b) exchange the share for a floating rate preferred share.
- The retractable preferred share permits the shareholder to redeem the preferred share at par value on a predetermined date. The issuer must either pay with cash or with common shares upon retraction, depending on how the retractable share is structured.
The rate reset preferred share is popular because it is somewhat adaptable in a changing interest rate environment. In the context of LDCs, this type of preferred share makes sense as it allows investors to protect themselves to some degree from fluctuating interest rates – one of the advantages of using equity rather than debt. There are several other features, however, of preferred shares that make them potentially quite useful for both investor and LDC issuer alike.
One of the main features that makes preferred shares attractive to LDCs is the lack of the same kind of voting rights as common shares. To be clear, preferred shares do not necessarily need to be non-voting and they can often have quite complex voting rights, but, they often are non-voting. This makes them ideal for use by LDCs and more politically palatable for municipal governments, since very little control over an essential service is being given up to a private entity.
As far as most municipalities are concerned the main goal of a municipally-owned electric utility is not necessarily profit maximization, but rather the provision of reliable service at affordable rates. This means that when an institutional investor, whose mandate is profit maximization, invests in and gains some control over an LDC, municipal residents may become concerned about the implications of these motivations for their electricity services. This is the entire purpose of electricity rate regulation – the ‘regulatory compact’. Preferred shares, which carry no voting rights and therefore restricted managerial control, may present an opportunity for LDCs to garner equity investment in a way that is much more acceptable to municipal residents.
Risks and Concerns
While preferred shares offer greater security and lower volatility than common shares, the reduced risk means that the potential return is reduced as well. The growth potential is not as high for preferred shares, and investors looking for something shorter-term with a higher payout will not be attracted by these investments.
More importantly, however, are the tax aspects. Municipally-owned LDCs enjoy a favourable tax status so long as they fall within a somewhat narrowly defined ownership structure. Not only may this status be compromised depending on the type and volume of preferred share issued, but also the implications of the taxable preferred share rules and dividend tax rates may be significant. These rules and consequences must be taken into account along with the context of the issuing LDC’s current tax status and existing capital structure.
Risk and tax implications considered, preferred shares offer a fresh approach to investment in electricity distributors which only a few Ontario municipalities have considered to date. Their lack of control rights makes them more appealing in terms of public perception, while their stability and greater security can be appealing to institutional investors. If municipal LDCs are looking to stimulate investment and/or take chips off the table while avoiding the ire of the public, these commonly used corporate tools are well-worth considering.
This article was prepared with the assistance of David Torchetti, an articling student in Gowling WLG's Toronto office.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.