Time to spinoff the BDC?

As the federal government looks to constantly modernize the workings of the Nation State, I think the time has come to consider the benefits of spinning off the Business Development Bank of Canada. When I say spinoff, I mean sell it, close it, take it public, remove the Crown Corp. status (anything) and see if it’s actually a business or just a hangover from the the Planned Economy era:

Plans for the creation of the Bank date back to 1939 and to the onset of the World War II. With an eye to the future, the government recognized that it would need to stimulate economic growth and help create new jobs for Canadians once the war ended.

The quote above is how the BDC describes the beginning of its mandate. Perhaps it is time to reconsider the need for the government to stimulate growth through 85 branches across Canada, when the Chartered Banks alone have >10,000 branch doors to knock on when an entrepreneur is seeking capital.

Something. Anything. Just not the status quo.

Our nation has many government institutions that continue to exist for a variety of reasons, including:

– need (such as The Canadian Forces)
– inertia (Canadian Wheat Board)
– inability of the private sector to provide the service (AECL)
– poor economics (VIA Rail)
– regional politics (Atlantic Canada Opportunities Agency)

But one entity remains a bit of a mystery, and that’s the Business Development Bank of Canada. In this context I’m not referring to their venture capital group (we’ve been in deals with them), as our country is not knee deep in VC firms these days. While there are other VCs to tap versus the government, what the BDC VC group appears to do is entirely consistent with the rest of the marketplace – in a good way. The deals are at market, and they proudly play by market rules.

What I am referring to is the domestic lending arm of the federal government. After 60 years in business, it isn’t like this is a new topic. But we recently lost a deal out west to the BDC (they inbounded with an offer of more debt than the company was asking for, but at a lower price as well), and it struck me as a ludicrous situation. Why is the government interfering and competing with the private sector?

Now, on pg. 13 of their annual report, the BDC claims to not be a competitor, which undoubtedly is to keep the current Finance Minister away from their turf, who recently pointed out that he wasn’t – as a rule – a fan of the government interfering in the private sector. Here’s what BDC wants the Finance Minister to believe:

“In its financing activities, BDC is a complementary lender in the marketplace. It operates where there are market deficiencies to complete the services made available by commercial lenders. BDC works with other financial institutions and partners to serve entrepreneurs.”

As a former Ottawa political staffer, I do understand the necessary role the government plays in filling in the gaps, both in terms of service provision and economic and/or political oversight. None of these roles appear to underline the reason why the BDC still exists today, however. And as for being “complementary”, they will outright try to beat the private sector on deals, and are well known to be “voracious” on price in Montreal, for example, when competing against the likes of Desjardins, RBC and RoyNat, etc.

Perhaps that’s why over 39% of the BDC’s $8.7B financing portfolio is in that province, despite having 23.5% of the population base.

When the government takes loans away from the private sector provider, that is what’s called a “zero sum” outcome; not complementary. When they win, the rest of us lose. And it isn’t even clear if the companies themselves win. While there may be many situations where BDC provides incremental debt capital for a business, there is no evidence that this capital was otherwise unavailable to the company in question.

And when the company does well, they are known to demand their interest make-whole, which can often equate to one third of the face value of the loan outstanding. A serious financial penalty. How is that good for a growing business?

As for providing lower cost pricing up front, if they in fact do provide lower pricing, that is solely explained by the Government of Canada’s issuing power and commensurate loss rates (ie., the BDC is not pricing for risk). Despite this cost-of-funds advantage, BDC achieves a Return On Equity (9.2% at last report) that’s half the competitive reality of most North American publicly-traded lenders. So, despite the lowest cost of capital available (in essence, soverign risk) the BDC is still only able to generate a return on equity – half – that would get a Bank CEO fired in the private sector.

And if the federal government’s goal is to earn a lower return on this Crown Corp. than they’d earn had they invested in the private sector, what public policy goals are being served in a world where dozens of lenders operate in the same markets?

If you take a quick review of the last annual report, several things emerge:

– BDC’s cost of funding its loans is fabulous: notes due in 2016 were issued at rates between 3.5% and 3.59%.
– although the BDC authorized $2.5 billion in new loans, the portfolio increased by only $0.7 billion. Either there was a huge runoff on the existing ~$8 billion portfolio (BNS has a $26B domestic “business and gov’t” portfolio, by comparison), or else the impact of the bank’s policy of paying employees their bonuses for authorized deals, rather than drawn deals, comes across pretty clearly here. How many firms pay their salesmen for leads vs. closed deals? What happens to that bonus if the deal never closes?.
– put a different way, of the $2.5 billion authorized, over $900 million was committed but undrawn as at the end of the 2006 fiscal year. A full 38% of the new deals signed up during the year hadn’t drawn, and may never, but bonuses still get paid on the entire amount. Unheard of in the private sector.
– the lowest effective rate for the undrawn authorizations was 5.1%. A year ago, prime was 5.5%, so the BDC was issuing commitment letters below prime rates. If the credit was of such a high quality, and thus deserving a rate that was below prime, why is the BDC taking that business away from the Chartered Banks? Moreover, these don’t sound like start-ups.
– the goal is to generate “an ROE at least equal to the government’s average long-term cost of funds”; two things come to mind: 1) if the current long term cost of funds is around 4%, isn’t that bar a tad low, and 2) if the actual ROE was 9.2% last year, that’s about half of what the Canadian Banks are generating for their shareholders.
– of the 8,500 transactions closed in that fiscal year, about 1/3 were required to have an environmental assessment under the Canadian Environmental Assessment Act. How many of those consulting reports (and fees) were really necessary?
– BDC has 85 offices across the country, yet their subordinate financing group authorized just $93 million for the year ended March 31/06 (about $1MM per office). Our firm led over $60 million during the same time period from just one office, for example.
– the “unamortized net actuarial loss” in the two employee pension plans exceeds $137 million; and they dropped the discount rate from 6% to 5.25% during the year, which will have had a handy impact on the value of the plan. BNS, for example, uses 5.75%. Ced Ritchie, former Chairman of The Bank of Nova Scotia (BNS:TSX) is the current Chair of BDC.
– as a Fund of Fund investor, BDC has $56.9 million of fund investments at cost, with a fair market value of $35.4. Considering how new the portfolio is, the unrealized loss figure is surprising.
– derivatives are very popular, with $7.7 billion on the books, up 13% year/year when the loan book grew by less than 9% versus 2005. In just one year, BDC increased the number of derivative counterparties it works with by two-thirds.
– the average authorization for a new loan in 2006 was less that $300,000; sounds very similar to the old SBLA program in terms of deal size. But, what it really appears to be is a series of small business loans that are probably alot more like personal credit adjudications rather than true business loans. Which is fine, but may well lend themselves to new on-line credit scoring technologies and not 85 branch offices.
– net income as a percentage of average loans has averaged 1.6% over the past 5 years.
– interest earned as a percentage of average loan portfolio is about 7.5% over the past two years, which is about 200 bps over the average prime rate; as spreads go, this reflectes a normal mid market commercial loan portfolio. Something that the Canadian banks are well-situated for.
– the general credit allowance has been about 4.6% for the past two years, versus Scotiabank’s 1.16%, for example. Add BDC’s specific credit reserve, and it hits 6% of the portfolio. In 2006, $71 million of loans were written off, and another $61 million was erased during the prior year.
– despite an excellent economic backdrop in almost every region of the country, the annual general credit reserve provision was increased by 62% in 2006, even though the loan book grew by just 8.6% (by way of example, both the general and specific loan provisions at BNS were flat, year over year). Put another way, financing net income was about $155 million, barely double the specific writeoffs in the same period. (Which is like the BNS writing off $3.25 billion, rather than the $276 million they actually did in 2006).

And the highlights don’t stop there, but I think you get the point. I’m all for competition, but with returns that are half the industry, and write-offs that are extremely high, the BDC does not appear to be running a business on market terms. If the government’s purpose is wealth creation and economic growth via the SME market, there are other avenues, such as the ones advocated by the Canadian Venture Capital and Private Equity Association (CVCA). If it is regional development, there are plenty of existing structures to support that strategy.

But the government no longer needs to be undercutting the private sector. And if the SME market needs this “uneconomic” model to keep itself afloat, perhaps individual Canadians deserve a national roll-out of government-owned ABM machines. How can the House of Commons Finance Committee (and the Dept. of Finance) claim that ABM machine fees are too high, and not do something about it? If the BDC is the government’s way of ensuring cheap capital is available to undercut one of the best banked economies in the world, they should get into the white label ABM business as well.

If you ask the Bank of Canada, they are pretty clear:

“When services and infrastructure projects are privatized, it is expected that more efficient private sector management will reduce government expenditures. For example, a private consortium may be better able to manage the financial risks involved in building an infrastructure facility, such as cost overruns or the withdrawal of contractors, than the public sector. The key to raising efficiency and lowering costs, however, is competition, not privatization per se. Therefore, the cost savings arising from the privatization of services or public works depend crucially on the terms of the contract. Overall, when structured to improve economic efficiency, privatization is likely to enhance the economy’s performance, thereby producing long-term economic and budgetary gains.”

If retaining the BDC is really the intention, let’s bring back the Bricklin. And Massey Ferguson. And Curragh Resources. And MIL-Davie shipyards. And Petro-Canada. And CN. And Air Canada….

But isn’t the government getting out of this racket?

With $138 million of pre-tax net income, and no obvious public policy role, perhaps a public floatation at 12-14x earnings is in order? Wouldn’t the government want to pocket $1.5 billion from a 100% spin-off (by comparison, Canadian Western Bank had a $1.49B market cap. on $69MM in 2006 cash earnings at last check), and see what the beast can do as an independent entity, borrowing in the open market at whatever the market would bear?

Or, the feds could always branch out into the white-label ABM business, as well. Don’t consumers deserve the same treatment, particularly in an election year?

MRM