Warren Buffett is coming to the rescue of Home Capital Group Inc., but the Oracle's support won't come cheap for the Canadian alternative mortgage lender.
Berkshire Hathaway Inc. has agreed to indirectly acquire $400-million of Home Capital's common shares – at a steep discount to the stock's current trading price – and provide a new $2-billion line of credit on slightly better terms than the emergency loan Home Capital received in April from the Healthcare of Ontario Pension Plan (HOOPP).
The backing of Mr. Buffett, one of the world's most-famous investors, is designed to shore up confidence as the beleaguered Toronto-based mortgage lender tries to stabilize its cash position and get its business back on track after facing liquidity crisis earlier this year.
Investigation: Home Capital mortgage lender was mere hours away from collapse
Shares of Home Capital soared 10 per cent in early trading on Thursday to $16.46. It's been a wild ride for investors: the stock is up 79 per cent over the last month, but still down 39 per cent over the last three months.
In a note to clients, Jaeme Gloyn, an analyst at National Bank Financial, said that the financial terms of the deal "validate the degree of stress HCG currently faces and the significant uncertainty that remains in the company's outlook."
But Home Capital called the Berkshire transaction, which was first announced on Wednesday night, a "turning point" for the company.
On a conference call with analysts on Thursday, board member Alan Hibben said that Home Capital explored a range of alternatives to the Buffett deal, including other equity and debt investments, asset sales and other credit replacement options. But the Berkshire deal was chosen because it included a well-known sponsor in Buffett who would validate the company's business model and its portfolios, as well as a lower cost of debt financing, Mr. Hibben added.
Home Capital has been in financial distress since April, when the Ontario Securities Commission levelled allegations against the firm and three former high-level executives of violating securities rules by failing to disclose problems in its mortgage underwriting business in 2014-15.
Depositors began pulling money rapidly out of Home Capital savings accounts and guaranteed investment certificates – a run on the bank that nearly led to the firm's collapse in early May. Since then, it has been selling off assets, making changes to its board and advertising lucrative interest rates on deposits in an attempt to win back the funds it has lost. It also agreed to a settlement with the OSC on the allegations that, if approved, will see it pay more than $10-million in fines and costs.
The company needed "someone who everybody out there could look at and say 'that is a smart investor – if that smart investor is willing to put common [equity] in this company, then I should be willing to invest in the GICs,'" Mr. Hibben said on the conference call.
For Mr. Buffett, this kind of bet is in keeping with his history of investing in distressed financial institutions on favourable terms, most famously in the United States during the 2008 financial crisis, when he invested billions in Goldman Sachs Group Inc. and other firms.
For Home Capital, the Berkshire investment is another step in the company's attempt to regain the market's favour. But it comes at a price.
The equity portion of the Home Capital deal is broken up into two chunks.
Through a subsidiary, Columbia Insurance Co., Berkshire will make an initial investment of $153.2-million to acquire more than 16 million shares of Home Capital, which represents a stake of nearly 20 per cent in the company. Each share will be issued at $9.55, which is a 36-per-cent discount to Wednesday's closing price of $14.94.
While such a deal would normally be subject to a shareholder vote, Home Capital is relying on infrequently-used clause in the Toronto Stock Exchange's company manual that allows corporate issuers to bypass a shareholder vote at a time of "financial hardship."
Mr. Hibben explained on Thursday's call that "the board determined that, due to the significant uncertainty created, the company is in serious financial difficulty," adding that this deal was still in the best interest of the company.
Home Capital expects the initial investment to close on June 29, pending the TSX's stamp of approval on the exemption after five business days. There is a holding period of four months attached to the shares.
Then, Berkshire has agreed to make another investment – also through Columbia – of $246.8-million to buy another 24-million shares of Home Capital at $10.30 per share. This deal, however, would be subject to shareholder approval, which will be sought at a special meeting in September 2017, and Canadian Competition Act clearance.
Analysts questioned whether shareholders of Home Capital would support Berkshire's second investment, with it being such a steep discount to today's prices. Mr. Hibben said "the board looked at this as a package," adding that "we did believe that our support of that second tranche was equally important as our agreement to take the first tranche."
When Home Capital struck its deal with Berkshire, the company had not yet settled its disputes with the OSC or announced plans to sell $1.2-billion in commercial mortgages to real estate private equity funds KingSett Capital. Both of these moves caused Home Capital's share price to rise.
Once both private-placement deals are completed, Berkshire would own a total stake of almost 39 per cent in Home Capital at an average price of $10 per share.
"While the equity investment represents significant equity dilution ... we view this equity investment as an important signal to all stakeholders that with support, Home Capital will remain a going concern and will work to chart a path back to profitability," said Brenna Phelan, analyst at Raymond James, in a note Thursday. "We continue to believe that the most important component of a return to profitability is obtaining lower cost funding (i.e., deposits) and we believe the backing of Berkshire Hathaway will be instrumental in achieving this objective."
Berkshire is also lending Home Capital $2-billion to repay what's outstanding on its existing $2-billion loan. On Wednesday, Home Capital said that $350-million was undrawn under the existing HOOPP facility. The new credit agreement is also expected to be effective June 29.
It is slightly cheaper than the HOOPP loan: There is no upfront commitment fee. The interest rate on outstanding balances will decline to 9.5 per cent from the current 10 per cent, while the standby fee on undrawn funds will decrease to 1.75 per cent from the current 2.5 per cent. Once Berkshire makes its initial investment in Home Capital, these amounts will drop to 9 per cent and 1 per cent, respectively.
As part of the agreement, both parties agreed that Home Capital could still complete other asset sales and financings as long as they do not compete with the Berkshire deal.