Hello Spotted, If Canada officialdom thinks it can lie, pilfer, rob, and strong-arm, it best think again on the royalty trust issue ...
My summary is The Private Equity guys are coming to the rescue. Buying them out, loading them with debt, and moving assets and headquarters offshore. So much for the Canadian Government grabbing more tax revenue ...
Speculators of the world, unite!
theglobeandmail.com
Private equity casts its eyes on bruised trust firms
SINCLAIR STEWART and BOYD ERMAN AND ANDREW WILLIS
From Saturday's Globe and Mail
The first e-mail arrived a little after 5:30 p.m., just as David Cynamon was sliding behind the wheel of his car. It was Halloween and, like many fathers, the chief executive officer of KCP Income Fund was rushing home to gather his kids and take them trick-or-treating.
He didn't think much of the first message. But his BlackBerry began vibrating again. And again. And again.
Within minutes, a half dozen investment bankers and private equity professionals had deposited e-mails in his inbox, alerting him to Ottawa's surprise decision to levy a tax on income trusts.
Of course, there was another motive at work. Virtually all of the messages asked the same question: Are you ready to go private?
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“They were all coming in, one after the other — that's how I knew it wasn't just one guy bouncing an old idea off of me,” Mr. Cynamon recalled. “I was reading while I was driving, which I shouldn't do, but it was like ‘What is going on?' It completely blew me away. I mean, even when I went trick-or-treating, I couldn't digest it. I didn't know if it was real or just a practical joke.”
It wasn't a joke, and Mr. Cynamon wasn't alone. Bankers and buyout funds could already see an opportunity to snap up some companies on the cheap, and they were on the line to income trusts across the country.
The phones were ringing at the Hamilton offices of Lakeport Brewing Income Fund, at the Moncton headquarters of PDM Royalties Income Fund and in Niagara Falls, Ont., where Amtelecom Income Fund's top executives were attending a board meeting.
Since the tax plan's announcement, trusts have taken a pounding on the stock market, making it tempting for CEOs to start returning those calls. For example, a fifth of the market value of bleach maker KCP has disappeared since the plan was unveiled, leaving it at $341-million. Most other income funds fared similarly.
Mr. Cynamon, who has considered going private before, said he is thinking of the option much more seriously after Ottawa moved to begin taxing existing trusts' distributions in 2011. “There's no doubt that — I don't know what the number is — but 50 per cent of the trusts out there I would believe are going to consider going, or actually go, private,” he said.
Most CEOs are still grappling with the news, and it's too early to tell how many are actively contemplating a decision to take their company private, either by seeking an outright buyer or by partnering with a private equity firm in a management buyout. But if private equity players do descend en masse on small to medium-sized Canadian income trusts, it could have some unintended economic consequences: namely, some of the same problems that Ottawa was attempting to fix with its new rules.
That's because private equity funds generally use leveraged buyouts, loading up their acquisitions with debt to create deductible interest payments that minimize taxable income. The irony is that's basically the same setup that early trusts used to avoid paying corporate tax.
On top of that, leveraged buyouts, because of the heavy use of debt, “limit reinvestment in capital assets,” Canaccord Capital Inc. analyst Chris Rankin warned in a note to clients on Thursday. “A systemic increase in leverage will reduce investment in businesses, reducing Canada's productivity.”
That's another one for the irony list. When he announced the clampdown on trusts, Finance Minister Jim Flaherty cited concern that trusts hinder productivity because of the temptation to skimp on reinvestment and instead pay out more cash to investors.
And should foreign buyers predominate (which may be the case, given the massive scale of the U.S. private equity business compared with Canada's), more corporate profits will be shuffled out of the country. The result will be tax avoidance, tax leakage and weak productivity, critics say. In other words, square one.
“We are going to see a transfer of public leveraged buyouts — the trusts — to private LBOs at the private equity funds,” predicted Barbara Gray, a top-ranked income trust analyst at Blackmont Capital. “My phone has been ringing off the hook, with the U.S. hedge funds and private equity funds looking for guidance on what to buy.”
PDM, which operates more than 100 Pizza Delight restaurants in Atlantic Canada, received calls from at least two private equity firms shortly after Mr. Flaherty made his announcement. “There certainly are going to be players who take that [privatization] route,” said Bill Lane, the trust's chief financial officer. “We have to look at things in a very different light today. Last I heard, we [had] got enough on our plate without having this wonderful little government ‘assistance,' shall we say.”
Investment bankers were also on the line to Teresa Cascioli, chairwoman and CEO of Lakeport Brewing. She has taken a wait-and-see approach, but acknowledged that taking Lakeport private could make sense, given the uncertainty surrounding the future of income trusts. “Why would I want to deal, with the mood of the government depending on how they feel when they wake up in the morning?” she asked.
There are a number of funds that would be relatively easy to take private because only a minority of the equity has been sold to the public. One example is Hartco Income Fund, a Montreal-based owner of 90 computer stores under banners such as MicroAge and CompuSmart that sports a market capitalization of just $32-million.
The fund, 65 per cent owned by Montreal entrepreneur Harry Hart, has not received any calls from private equity firms, but “will look at all possibilities, including private equity and other alternative structures,” CFO Carl Gauvreau said.
“If you've lost 20 per cent or 25 per cent of your value, it's going to take you maybe two years of work to get that back,” said one senior deal maker. “A lot of these people have a lot of their net worth tied up in the trusts they run, so they are going to be tempted to say ‘Why don't I just partner up with a sponsor and go private?'”
The debate now is not over whether some trusts will disappear in acquisitions or going-private transactions: It is over how many, and how fast.
“I think there will be a frenzy of activity,” said one Canadian private equity professional. He predicted most of the buyout funds will be targeting small- and mid-cap trusts, and that the takeovers would begin in “months, not years.”
The private equity industry, after all, is swimming in a glut of cash as the lure of hot returns has drawn a record $160-billion (U.S.) of new capital to buyout funds this year, researcher Private Equity Intelligence estimates. That represents immense buying power, because for every $1 of capital, funds typically borrow $2 or $3 more to pay for acquisitions. At the same time, the competition for targets has left fewer places for them to spend their money.
“There's no doubt that there's a lot of private equity money that needs to be put to work,” said Randall Pratt, a lawyer at Osler Hoskin & Harcourt LLP who advises these funds. Mr. Pratt said he has been fielding several calls from U.S. fund lawyers looking to gauge the implications of Ottawa's move. “There are lots of business trusts that I think are going to attract a lot of attention.”
Infrastructure trusts will also attract attention, predicted Sandy McIntyre, one of the country's biggest trust investors as a senior vice-president at Sentry Select Capital Corp. “The pension funds will focus on these plays,” he said, highlighting Fort Chicago Energy Partners LP, Inter Pipeline Fund LP and Taylor NGL LP as likely targets.
“Look at the massive recent trading volumes in trusts,” he said. “You know these buyers aren't all stupid. There's been massive buying by U.S. hedge funds that are counting on selling to their private equity fund cousins.”
Even so, pension and private equity funds have a reputation as bargain hunters, and many trusts, notwithstanding their recent plunge, are still not cheap enough, bankers said. All most of the trusts have done so far is shed the premium they were fetching over traditional corporations, so a further drop in prices may yet be necessary before the bids start coming in.
Also, private equity firms generally prefer to buy private companies in handshake deals, avoiding auctions that run up prices. That's impossible with a publicly listed trust because any bid prompts the board of trustees to start an auction process to drum up higher offers. It doesn't always work, but it adds risk that private equity buyers prefer to avoid.
“Taking a company private, whether it's an income trust or its shares are listed, adds a layer of complexity and cost to the transaction,” said Tom Kennedy, president of Toronto-based Kensington Capital Partners, which runs funds that invest in private equity funds.
“I don't think all of a sudden the PE firms, that I'm familiar with anyway and we think we know a lot of them, are going to go rushing out and buying public companies or public income trusts,” he said.
That won't necessarily stop a wave of buyouts. Instead, it may just shift some of the focus to privately held companies whose plans to go public as income trusts have been scotched by the federal government's decision.
For most of the past five years when a company wanted to sell, the owners looked at selling to private equity buyers, and at going public as a trust. Often, because of the popularity of trusts, that's where the higher price came, leaving private equity firms the losers in bidding.
“It should help private equity acquire interests, because there won't be the alternative of going to an income trust,” said Jim Leech, who heads the private equity group at the $96-billion Ontario Teachers Pension Plan. “Over the last four years we've bid on a number of things where they decided ‘Nah, we're going to go out as an income trust instead.'”
While the buyers are happy, the potential sellers are not. KCP's Mr. Cynamon, like many executives, remains more than a little steamed about the situation Ottawa has left him in.
“I've never seen anything like this in my life, what they can do,” he said of the government's decision. “If this happened in the regular business world, you'd be sued, you'd be arrested.”
His board of directors met the day after the announcement to discuss the implications, and advisers are counselling the company on options that include going private.
Another option is moving to the United States, yet another unintended consequence of Ottawa's surprise tax announcement. Like many trusts, KCP derives a big chunk of its income from the United States, and Mr. Cynamon insisted it's possible that the company could simply shift its operations southward and list in the U.S. markets, where taxes are lower.
Either way, Canadian governments would lose tax revenue, and maybe the country loses yet another head office.
“This might force us to get out of Canada completely,” he said.
With files from Andy Hoffman
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