Encana deal’s low fees serve as warning to Bay Street

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Canada's largest companies now have a proven lower-cost way to sell shares after Monday's $1-billion (U.S.) equity sale by Encana Corp., and if this approach to financing catches on, investment banks will see their underwriting fees slashed.

Credit Suisse Securities Canada Inc. and JPMorgan shocked Bay Street by helping Encana, one of the country's largest energy companies, raise money with a share sale that resembled a block trade of stock, done for a 1.8 per cent fee.

That is less than half of the 4 per cent commission typically charged on a Canadian equity sale, and the deal has kicked off a heated debate in banking circles.

In simple terms, the two foreign banks are saying Canadian companies pay too much to issue stock. In equally simple terms, many Canadian bankers say Credit Suisse and JPMorgan are getting too little reward for shouldering a $1-billion risk.

The fact that this innovative transaction was done without a Canadian investment bank in a leading role also has heads spinning on the Street: Large equity sales almost always feature at least one domestic dealer.

Corporate Canada will determine who is right, as Encana's approach to raising money would work for any Canadian company that lists its shares on a U.S. exchange. And there is nothing proprietary about what Credit Suisse and J.P. Morgan did: Any domestic or foreign bank can replicate the tactics. Capital hungry public companies in sectors such as rail, airlines, consumer products, and mining and resources can all expect to hear a pitch.

Sources familiar with the transaction said Encana executives signed on because raising cash this way cut their costs while providing the same certainty they could raise a $1-billion that comes from the made-in-Canada alternative, known as a bought deal. In this approach to underwriting, investment banks buy stock from a company at a set price, and shoulder the risk of selling the shares to the public.

Spokespersons for Encana, Credit Suisse and J.P. Morgan declined to comment on Thursday because the share sale had not closed.

The mechanics behind the Encana share sale were worked out during countless U.S. stock sales in recent years, but this week's financing was the first time a Canadian company has used what is awkwardly known as a "block trade net pricing model" to sell shares. J.P. Morgan, Credit Suisse and Bank of America Merrill Lynch gave the concept a test drive last month by using it to sell Pershing Square Capital Management's final block of $1.45-billion shares in Canadian Pacific Railway Ltd.

In Encana's share sale, the investment banks guaranteed the oil company would raise $1-billion by selling stock at a price within a set range – in this instance, between $9.35 and $9.70 a share. If the price came in at the top end of the range, Encana would benefit, as its shareholders would see less dilution, and the dealers would receive a higher fee. This underwriting ended up being priced at $9.35, the lower end of the range, and that meant a minimum 1.8 per cent fee.

While the fees on each underwriting will vary, sources familiar with the Encana transaction said the total cost of the block trade approach should consistently be less than 7 per cent of the total underwriting. In contrast, the total cost of a bought deal typically is typically above 7 per cent, as new equity is sold at a discount to where the stock is trading, which is a cost to the company, and that discount would be added to the 4 per cent fee paid to the dealers.

Encana also wanted to target U.S. institutional investors with this share sale, on the assumption that they attach a premium valuation to the company's Permian oil fields in Texas. Encana is spending half the money it raised to develop this property, the rest will be used to pay down debt. The foreign dealers like to claim Canadian bought deals typically end up being sold to a company's existing investors, with a focus on Canadian fund managers – another assumption that is hotly debated in banking circles.