Preferred share deals feed Bay Street with millions in fees

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Retail brokers and a select group of investment bankers have a lot to be thankful for this year. The deluge of preferred share financings by Canadian banks has served up a boatload of fees.

Since January, roughly $5-billion of bank preferred shares have been issued because Canadian lenders are grappling with new global regulations. In order for their preferred shares to count as bank capital, they've had to re-purchase outstanding shares and replace them with new securities that conform to regulators' expectations.

The flurry of deals has arguably generated easy money for Bay Street – especially for retail brokers. In an era without income trusts, preferred shares have been relatively easy sells because interest rates remain at rock bottom lows and Canadian investors still crave the higher yields that preferreds offer compared to common shares.

Just look at all the increases to preferred share deal sizes for proof. Typically the banks will look to raise between $200-million and $300-million. Yet in many cases, in just a matter of hours, their offerings have been increased to $500-million – such as the case with Toronto-Dominion Bank's issue last week.

Calculating just how much money is made from these deals can be a bit tricky because the fees change depending on the mix of buyers. For sales to retail investors, the issuer pays a 3 per cent fee, roughly half of which goes to the retail broker; for sales to institutional investors, the issuer pays a 1 per cent fee.

The split between retail and institutional sales has changed from deal to deal because institutional investors are more likely to sit on the sidelines when the issuers get aggressive with their pricing. But if you assume a two per cent fee on average – a reasonable estimate because retail investors are the most common buyers of preferred shares – it means $100-million in fees have been paid out this year, mostly to replace existing shares.

And there will likely be more of these fees. Earlier this year, rating agency Moody's Investor Service estimated that Canadian banks will reissue up to $20-billion worth of preferred shares to comply with new global regulations.

The fee bonanza has aggravated some smaller dealers that aren't included in preferred share underwriting syndicates, or that get very small slices of the pie when they are. Despite a surge in fees paid to investment banks this year, smaller dealers are still suffering, and some have voiced frustration about not being in on the 'easy money' deals like preferred share financings.

However, the situation isn't so clear cut. The underwriters invited into these deals are typically those with retail brokerage networks, so they have a means to sell preferred shares to retail clients; they get paid for having the right clientele.

Also, these offerings aren't always as easy to sell as it may appear. The latest offerings were structured as bought deals, which means the underwriters absorb the risk of the financings not selling. (In a bought deal, if underwriters can't get their clients to buy the shares, they're stuck with them.) Even though the deals are selling well now, all it takes is for one or two deals to get hung because the pricing is out of whack, and then the syndicate suffers badly. Investment bankers will tell you that cleaning up hung preferred share deals is no fun.

That said, the dealers have gotten smarter about the way they sell these offerings. Instead of launching large deals from the get go – the issuers have a lot of these preferred shares to refinance – many have chosen to start small and see just how much demand is out there. If the orders come flying in, the underwriters simply increase the deal size for the issuer, arguably sidestepping the risk built into the bought deal model.