A matter of trusts

When Canada's current prime minister, Stephen Harper, was on the campaign trail, he promised not to tax Canada's many investment trusts, explaining he wanted to protect the savings of senior citizens vested in the trusts. He took office in January 2006, and by Halloween, his finance minister James Flaherty announced there would indeed be a new tax on the trusts. The response among the trust community wasn't surprising. One critic posted attack ads against Harper on YouTube, featuring the politician's trust pledge repeated over and over.

Private equity GPs, on the other hand, have had a hard time suppressing their excitement at the prospect of Canadian income trust after Canadian income trust seeking to go private now that a key tax advantage has been rescinded. “A lot of these companies turned into trusts because they could, not because they should,” explains Peter Gottsegen, a managing partner at the private equity firm CAI Capital Partners.

The Canadian investment trust is an ownership structure for “income producing assets” that trades its shares or “units” on securities exchanges, much like stocks. Trusts make regular distributions to investors, or “unitholders,” on a monthly or quarterly basis. The trust entities are structured using affiliated thinly capitalized companies, which are illegal in the US and other markets. Most notably, these trusts' special tax status made the structure popular among investors and companies looking to raise capital.

The income trust has existed for a little over two decades in Canada. The main attraction of the trusts is that these entities are not taxed at the corporate level. A boom in trust formations began in 2000 and continued through 2005, when the value of the trust market grew from $18 billion to $200 billion.

In fact the trusts may have become too popular for the government's liking. Some industry observers believe the finance minister pursued a policy shift in the wake of Telus and Bell Canada Enterprises announcing a conversion to the trust structure.

The finance minister made his announcement on Halloween 2006, leaving many trust participants to feel as though Flaherty used the holiday to turn their carriages into pumpkins. Income distributed to unitholders will now be subject to a new 34 percent tax to serve as the trusts' version of the income tax paid by corporations. This would mean that a unitholder who used to receive $66 of a $100 distribution would now receive $46. Given their nonprofit designation, pension funds will be hit the hardest. One GP explained that pension fund managers are among the harshest critics of the policy shift.

The proposal does provide for a transition period during which income trusts formed on or before the date the policy goes into effect will not be subject to the new rules until 2011, though few managers are waiting four years to respond to the new regime.

SALE PROCESS
Since the surprise announcement, 17 publicly traded trusts have been sold, representing an exit of $13.2 billion of value from the trusts markets. Fourteen more trusts have announced “strategic reviews” a term which local newspapers have referred to as a euphemism for “sale process”.

Of particular interest is the fact that many of Canada's oil and gas companies use the trust structure. A recent research note from the investment brokerage Canaccord Adams suggests the new tax policy could have the unintended consequence of reshaping the country's energy policy. The note explains that tightening the reins on trusts raises the price of domestic investment, thereby slowing growth of the country's energy market and dampening tax revenue in the long term. Furthermore, the policy encourages foreign ownership of Canada's energy assets given the many international buyout firms with the capital and appetite for these assets. The note continues to bemoan the decline of the structure by citing the high rate of reinvestment among the trusts in development activity, ostensibly crediting the trusts with building the country's energy independence in the process.

However, the energy trusts haven't fled in droves to foreign owners yet. At press time, only one such income trust, Calpine Power Income Fund, has been purchased by a US private equity firm.

Diane Ablonczy, the MP for Calgary Nose Hill and parliamentary secretary to the finance minister, has told constituents that concern over foreign investment firms are an “alarmist view” of the consequences of the tax change. Flaherty himself dismissed critics that blame the tax proposal for the sell off among trusts. He points to the amount of private equity looking to be deployed around the globe, and finds the trusts among the many assets being acquired. He stressed to the local media that these acquisitions are “taking place all over the world.”

Despite the finance minister's arguments otherwise, certain executives have been vocal in blaming the tax change for driving them out of the trust structures. In April, the KCP Income Fund (KCP), the parent company of Ontario-based consumer products company KIK Custom Products, entered into a definitive agreement to be acquired by Caxton-Iseman Capital, a US private equity firm.

The transaction grew out of recommendations from a special committee formed by KCP right after the finance minister's Halloween announcement. The special committee was commissioned to identify and explore strategic alternatives and James Arnett, chairman of that committee, said they voted unanimously for the deal.

David Cynamon, KCP's founder and CEO, told the Globe & Mail there are few Canadian entities that have the “heft” to compete with private equity offers. He explained that prior to the tax change the income trust structure provided a sufficient advantage over the buyout route. With that advantage gone, his business couldn't argue against a sale to a private equity firm. He predicted more of his peers among the income trusts will follow suit.

ENTER THE BARBARIANS
Private equity did constitute 45 percent of the $13.3 billion in sales of trusts so far. That said, despite hand wringing about the flood of buyout dollars, there are several factors that could keep that flood a trickle. Removing the tax advantage may prompt trusts to sell, but it doesn't guarantee GPs will buy.

“These trusts aren't priced modestly,” says Gottsegen. Some analysts of the trust sector have suggested that private equity may very well stay in the sidelines, waiting for prices to drop. Granby Industries Income Fund, a domestic leader in the steel storage tank sector, is priced at a relatively rich eight times EBITDA. As the grace period winds down, many GPs expect the trusts will lower their valuations if the offers don't arrive as expected. One private equity observer suggested that prices may not need to drop that dramatically by 2010, as GPs could be eager at that time to deploy the mounds of capital they've raised of late.

Private equity firms may also find that the truly attractive assets avoid them altogether. “Some of the stronger enterprises may simply list as common stocks on the public markets,” says Sam Duboc, president and managing partner of Toronto-based private equity firm Edgestone Capital Partners.

Another analyst said in that the trusts vary in quality by a large margin, and it's too soon to tell how many will pass the rigors of a buyout firm's due diligence.

The new tax policy may well shrink Canada's income trust market, but how the trusts respond will be anything but uniform. Some will stagger through the new tax regime, some will become traditional public companies, and some will be acquired by private equity firms. Just how many remains to be seen, but the fact that private equity plays such a key role in the debate speaks volumes about the current stature of the asset class.