is the trust in trusts misplaced?resulting trust is riskier than the average, but this is no...

RESEARCH BY

Professor Paul Halpern, Professor of Finance

TSX Chair in Capital Markets

Rotman School of Business, University of Toronto

Is the Trust in Trusts Misplaced?

RESEARCH SPONSORED BY THE INVESTMENT DEALERS ASSOCIATIONOF CANADA THE NATIONAL SELF-REGULATORY ORGANIZATION ANDREPRESENTATIVE OF THE SECURITIES INDUSTRY.

A Study of Business Income Trusts and Their Role in Canadian Capital Markets

Is the Trust in Trusts Misplaced?

A Study of Business Income Trusts and Their Role in Canadian Capital Markets

Research by: Professor Paul Halpern, Professor of Finance

TSX Chair in Capital Markets Rotman School of Business, University of Toronto

Acknowledgements Many individuals and organizations generously provided their time and data for this report. To avoid the crucial error of inadvertently omitting someone, I will thank their organizations: BMO Nesbitt Burns, CIBC World Markets, Investment Dealers Association of Canada, and TSX Market Data Services. I want to thank my research assistant Yang Lin for her dedication and perseverance.

Is the Trust in Trusts Misplaced? i

Table of Contents

1.0 Executive Summary 2.0 Introduction and summary 3.0 Business Trust Structure

• Comparison with limited partnership • Characteristics of firms that can use the structure • Distribution policy

3.1 Benefits of the Trust Structure 3.1.1 Tax Efficiency 3.1.2 Agency cost of ‘Free Cash Flow’ 3.1.3 Financial Distress costs 3.1.4 Facilitating venture capital exits and restructuring strategies 3.1.5 Efficiency of market

3.2 Potential Issues 3.2.1 Tax losses to Government 3.2.2 Impact of Third Party debt and ultimate default 3.2.3 Inappropriate companies using the structure 3.2.4 Governance issues

3.3 Attributes for Investors 3.3.1 Retail Investors 3.3.2 Pension funds

4.0 What we know about the financial instruments and companies using them 4.1 Initial Public Offerings

• Is pricing different from IPOs of non-trust structures? • Post issue stock performance

4.2 Conversions 4.3 On-going Companies

4.3.1 Performance, Distributions and sensitivity of rates of return to economic factors a. Performance b. Distributions c. Sensitivity to economic factors and abnormal returns

4.3.2 Follow-on financings 5.0 Implications

5.1 Income trusts in the index 5.2 Federal Budget proposal on pension fund holdings of business trusts:

The impact on the Business Trust market

Is the Trust in Trusts Misplaced? 1

1.0 Executive Summary All forms of income trusts have been a part of Canadian capital markets since at least 1995. Their importance in terms of IPOs has been significant since 2002. Business trusts have had substantial growth both in numbers and dollar value with 53 of 70 business trust IPOs since 1995 occurring since 2002. It is no surprise that the growth of business (and other trusts) has coincided with reaction to the tech period. Currently, the income trust market value is approximately $100 billion in market capitalization. Although substantial, this pales in comparison to the TSX market capitalization of approximately $1.2 trillion. In fact, the largest income trusts would be placed below the 40th ranking in the TSX/S&P 60. Income trusts are equity securities sensitive to both interest rates and overall market influences, with a higher impact from the former. In comparison to non-trust equities, their IPO behaviour, including underpricing is similar. As well, they make use of follow-on offerings. The largest user of follow-on offerings is the oil and gas trust class which must finance growth through new issues; business trusts rarely make follow-on offerings. In terms of stock market performance, each trust type outperformed the TSX index in 6 out of the 9 years between 1996 and 2004 on a portfolio risk adjusted basis. Moreover, when economic factors are taken into account, trusts appeared to be priced correctly based on interest rate and overall stock market risk measures. Interest and growth in business trusts can be attributed to a number of factors:

• The secular decline in interest rates which has made the cash distribution element of trusts more valuable:

• The desire by investor classes, both retail and institutional, for securities with dependable cash flows and low risk;

• The recognition that excess cash available to management may not be invested in profitable investments, thereby reducing share value. High distribution payout alleviates this tendency and increases share value;

• The tax efficiency of the structure, whereby tax at the corporate level is eliminated and distributions are taxable in the hands of investors. Preliminary work shows that gains to shareholders in a conversion from a non trust to a trust structure come from more than the tax effect.

• Unitholders, who own both equity and internal debt of the operating company, will agree to a reduction in distributions even, if in the form of interest payments, in response to a reduction in cash flows without incurring distress or default.

Not all companies can use the business trust structure effectively. Companies that can use the structure have the following characteristics: a low ratio of fixed to variable costs, a mature company, little competition, little or no technological change, limited capital expenditures, products with strong consumer loyalty and a low sensitivity to the business cycle—non-cyclical cash flows. Not all business trusts have these characteristics and thus will be of higher risk to investors. Other benefits of having a strong business trust market is that they facilitate exits from venture capital investments and assist in restructuring activities that create wealth for shareholders. A number of venture capital projects are large infrastructure projects that have characteristics appropriate for a business trust.


Concerns are also voiced about the trust structure. These concerns and our reactions are presented below:

• Tax losses potentially associated with the business trust structure could become large. Research on this topic is not clear on tax loss size. There may be no tax loss when the present value of taxes paid by beneficiaries of pension plans or RSPs is considered.

• Ratio of third party debt to equity can be large and lead to large risk for unitholders. Data suggest that debt ratios are not high given that companies have relatively stable cash flows.

• Governance of business trusts is less stringent than typical corporate forms. While governance can be different there are also similarities. Further, management behaviour is being affected by both securities regulation and the listing requirements of exchanges. Since trust and non-trust entities are influenced by both elements, differences in governance are minimized

The analysis concludes that income trusts (business trusts) are legitimate financial instruments that have a place in retail and institutional investors’ portfolios. There may be situations where a company with inappropriate operational characteristics has used the structure, and where the resulting trust is riskier than the average, but this is no different from any other equity security where there are companies of different risk and different degrees of success. It is important that the capital market recognizes differences in income trust quality and prices them appropriately. Appropriate pricing will most likely occur when capital markets are deep and there is sufficient analysis of companies by retail and institutional investors. The income trust market has been moving in this direction although proposed (and currently suspended) budget provisions could operate to slow or stop this progress.


2.0 Introduction and Summary

Questions: Which financial security class has generated positive rates of return while the overall equity market either had negative or smaller rates of return? Which financial security class paid out a large and steady proportion of its cash flow to investors while other securities failed to deliver on promises of growth? Which financial security class, by virtue of its structure, induces companies to reduce expenditures in unprofitable investments while other firms continue, unconstrained to make these investments? Answer: Income trusts in general and business trusts in particular. It is no surprise that the appeal in these securities at the retail level, by individuals and mutual funds dedicated to these trusts as well as at the institutional (pension fund) level has increased dramatically. The special characteristics of these securities have filled a need in the market place. Income trusts however, continue to generate polar reactions from analysts and investors. On the one hand there are analysts who believe that income trusts are overvalued and owe their success only to investor irrationality. On the other is the argument that income trusts are legitimate and viable financial instruments useful for certain investors and their portfolios. The irony in this debate is that Oil and Gas trusts and REITs have been available to both retail and institutional investors for many years; their costs, benefits and methods of valuation are well-known. REITs are also available on the U.S. stock market. Thus the concern expressed by some investors and commentators is focused on business trusts which encompass a large number of different corporate operations. The purpose of this report is to investigate income trusts, with an emphasis on business trusts. We identify costs and benefits to investors and valuation from the structure, their stock market performance, and their growth. We comment on the current discussion about their impact on government tax revenues. We do not evaluate whether specific income trusts are priced properly although our discussion will consider variables that are important in their valuation. Our concern is whether or not income trusts (business trusts) are legitimate and viable financial securities appropriate to companies that have specific operating characteristics and whether or not income trusts can be included in retail and institutional investor portfolios. Our analysis concludes that income trusts (business trusts) are legitimate financial instruments that have a place in investors’ portfolios. There may be situations where a company with inappropriate operational characteristics has used the structure and where the resulting trust is riskier than the average but this is no different from any other equity security where there are companies of different risk and different degrees of success. What is important is that the capital market recognizes differences in income trust quality and prices them appropriately. Appropriate pricing will most likely occur when capital markets are deep and liquid and there is sufficient analysis of companies by retail and institutional investors. The income trust market has been moving in this direction although, as noted in this report, proposed (and currently suspended) budget provisions could operate to slow or stop this progress.


Income trusts are defined in this report as a generic term encompassing a number of different business types. For example, income trusts include power trusts, Oil and Gas trusts, Real Estate Investment Trusts (REITs) and business trusts. Oil and Gas and REIT structures have been available in capital markets for many years while business trusts are relative newcomers to the capital market. In our discussion, while we consider all forms of income trusts, the greater part of the analysis focuses on business trusts. This focus arises for a number of reasons: first, this is the area in which potential growth is highest; second, unlike REITs and Oil and Gas trusts in which there is some commonality of operations within each trust form, business trusts can range over a number of different types of businesses, each with potentially very different operating characteristics. There are a number of ways in which an income trust can be established. At one extreme is a conversion from a regular corporate structure that has publicly traded equity to an income trust structure. As of June 2004, there were 42 trusts that have converted to the trust structure and others awaiting the change. Typically, a company announces its intention to convert to the structure; this announcement is followed by an increase in share price. There have been situations where an announcement was not followed by the conversion; e.g. Manitoba Telephone. In other situations, the decision is not straightforward and management continues to weigh the costs and benefits of the income trust structure and identify the best way to structure the conversion. An example is Penn West Petroleum for which speculation of a conversion was widespread before the announcement. We continue this discussion with publicly traded companies. There are situations in which the company has a number of divisions or subsidiaries with dissimilar operating characteristics. An example is the Oil and Gas area in which there are exploration and development operations. The former is riskier and more capital intensive in terms of growth than the latter. Financial research has demonstrated increases in share value when companies either spin off or sell off divisions or subsidiaries.1 When a company spins off a division or subsidiary to become an income trust through an Initial Public Offering (IPO), the benefits also include those that derive from the income trust structure. At the other end of the spectrum are private equity/venture capital or private companies where the current owners’ investment is illiquid and a decision is made to take either a full or partial exit from the private structure in order to provide liquidity. The income trust IPO provides an alternative exit vehicle to the standard IPO. In the private equity area, investors include large institutional investors such as pension funds as well as private equity specialist companies. Some private equity investments are infrastructure investments. An example of a large IPO of a private equity investment is Yellow Pages which not only had an IPO but also two follow-on secondary offerings. Over the more recent past, income trusts have become an important element in the capital market reflecting an increasing proportion of the TSX in terms of market value and particularly in the fund raising part of the market. Table 1 below provides the number and market value of all income trust and non income trust Initial Public Offerings in excess of $10 million (Canadian) over the period 1995 to mid-September, 2004.

1 The benefits include the focus by management on basic business, a clarity premium arising from separate evaluation of the pieces separately, better information and the existence of a new security in the market place.


In terms of number and market value, a peak for income trusts was reached in 1997, a quiescent period from 1998 to 2001 and a strong upward surge from then onward. In fact, the largest amount of trust IPOs, by dollars, occurred in 1997. As of mid September, 2004, there were 14 IPOs with a market value of approximately $1.8 billion. The average dollar size of these trust issues fluctuated over the time period, with average sizes above $129 million since 2001. The IPO statistics for non-trusts provide an interesting comparison. In 1996 and 1997, trust IPOs were approximately 46% and 63% respectively of total IPO financings by dollar value. During the ‘tech’ period of 1998 to 2000, the income trust IPOs percentage of total IPOs was small, reaching a low point in 2000 of 0.0% reflecting the market’s interest in high growth companies. Following 2000 the importance of the income trust IPO was reestablished when in 2002 and 2003 almost 90% of the issues were by income trusts. The non-trust IPOs number for 2000 to 2003 was a modest 5 per year which reflects the importance of income trusts in the capital markets. There is a wide range in size of trust IPOs over the time period. The largest issue was $1 billion for Yellow Pages in 2003. There does not appear to be a trend to larger issue sizes in the data. The lack of large issues may be the result of a limited interest by the institutional (pension fund) market in business trusts due to perceived problems of unlimited liability for the structure and governance questions. With these ‘problems’ alleviated, the ability of the market to digest issues of larger size will be improved. As documented later in this report, income trusts are sensitive to changes in interest rates and in the overall stock market. Thus there is a relationship between the number and market value of IPOs with market performance as found in the overall stock market and interest rates. In Figure 1 we plot the number of Trust IPOs, the Government of Canada 5 year bond interest rate and the value of the TSX index. The five year bond rate is used instead of a shorter term rate since the decision to engage in an IPO will depend upon the level of longer term interest rates.

Table 1: Number and Market value of Trust and Non-Trust equity IPOs $000,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004*Trust Unit ($Cdn) 570 2,438 6,503 748 126 0 1,333 5,358 4,348 1,803Number 2 16 32 6 2 0 8 36 21 14 Average size 285 152 203 125 63 0 167 149 207 129 Common Equity 1,816 2,860 3,774 1,959 4,099 5,129 766 745 493 1,603Number 17 36 38 25 20 34 5 5 5 20 Average size 106.8 79.4 99.3 78.4 205.0 150.9 153.2 149.0 98.6 80.2 Trust as % of total 24 46 63 28 3 0 64 88 90 53 market value *September, 2004 Source: CIBC World Markets


Figure 1:

Number of IPOs,GOC 5yr Bond Yield, TSX Index 1995-June 2004 Quarterly

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Number of Isssues GOC 5yr Bond Yield S&P/TSX Composite Index(Adj. Close)

As can be observed in Figure 1 above, over the period beginning in 1995, there was a secular decline in interest rates with an upward movement over the 1998 to 2000 period. Over the total period the TSX index rose until 1998, retrenched and then had an equally spectacular increase and decrease over the 1998 to 2001 period. This spike in value reflected the ‘tech’ stock era and during this period the market valued growth over large and sustained dividend payments. Over the 2002 to 2004 period, the TSX enjoyed an increase and interest rates fell. As expected, there appears to be an association between the number of trust IPOs and interest rate and market movements. A large number of trust IPOs occurred in 1996 through 1998 following a reduction in interest rates and an increase in the overall market. The next sub-period found very few IPOs as interests rates increased and the market was focused on growth stocks. Over the last sub-period starting in 2002, the large number of issues reflected falling interest rates, an interest in stocks that paid distributions and a rising equity market. A similar relationship is observed when the market value of IPOs is plotted along with the interest rate and market value of stock index series. The pattern of trust IPOs over the period is not the same for all trust types. In Table 2 we present IPOs by trust type for each year in the sample period.2 In terms of total numbers, business trusts are the largest category with 65 IPOs followed by 22 REITs and 18 Energy Trusts. The bulk of the

2 The data was provided by CIBC World Markets. The coverage is not as complete as the IDA data, but the sample is sufficiently complete to generate reliable conclusions.


business trust IPOs occurred in 2002 and 2003 with 42 issues. There were 13 issues over the 1995 to 1997 period. Power trusts began with a flurry in 1997 and then re-emerged in the 2002 to 2004 period. Energy trusts and pipeline/power trusts are the most senior of the income trust structures with 16 of the 18 energy trusts issued over the period 1995 to 1998 and all of the pipeline/power trusts issued over the period 1996 to1999. Finally REIT IPOs were spread across the whole time period with the exception of 1999 and 2000. The business trust structure also had the largest range of values of IPOs reflecting the different types of companies that used this structure.

No. Average Range No. Average Range No. Average Range No. Average Range No. Average Range1995 1 300 1 2701996 2 365 480-250 12 122 249-35 1 163 1 821997 10 236 870-47 6 203 538-23 2 172 203-141 7 163 305-75 3 311 375-2391998 1 42 2 156 205-145 2 189 296-831999 1 86 1 4020002001 4 149 190-121 1 212 3 175 205-1542002 28 145 444-40 2 266 268-265 1 35 5 134 307-542003 14 225 1000-60 3 172 201-172 1 203 3 159 222-502004 11 120 222-43 2 181 212-149 1 119Total 70 15 18 22 7

*blank entry reflects no observationSource: CIBC Securities

Table 2: IPO by Trust Type over 1995 to September 21,2004

Business Trusts Power Trusts Energy Trusts REIT Pipeline/Power(Market Values in $000)

As can be seen by the above discussion, income trusts in general and business trusts in particular are an important part of the Canadian capital market. With the reduction in issues of high growth companies following the retrenchment of the stock market, trusts have been the major factor in the IPO market.


3.0 Business Trust Structure Whereas trust structures can be complex, they are designed to generate single entity taxation, at the unitholder level. There is a variety of trust structures in use; the essence of the business trust structure is presented in Figure 2 below: Figure 2:

Unit holders

Trust

Operating companyOutside (third party debt)

External management (could own units)

Business Trust Structure

Buy unitsdistribution

Buy internal debt and equity

Fees interest

Cash to trust

At the Initial Public Offering (IPO) stage, investors purchase trust units and the funds are used by the trust to acquire subordinated debt and equity issued by the operating company (or sold as a secondary issue by existing shareholders). The operating company is generally a limited liability corporation. The trust unitholder, through ownership of trust units, is now both a shareholder and lender to the underlying operating company. Debt owned by the trust is typically large in dollar amount relative to equity and consequently has a yield reflecting this ‘leverage.’ Some commentators have likened this debt to high yield (junk) bonds in terms of its leverage and associated yield. Note that debt purchased by the trust is not the same as debt issued to third parties such as a bank or other financial institution. The term leverage is placed in parentheses, since the unitholder owns both internal debt and equity of the underlying operating entity. In effect debt and equity are stapled together and the unitholder has a claim to underlying cash flow of the operating entity after payment of interest on third party debt. This ‘internal’ debt is used to eliminate operating company corporate tax through interest deductibility. The internal debt level and interest rates are set deliberately, within reason, in order to generate this result. Hence unitholders in effect have an equity security given that they are residual claimants to the overall cash flow of the operating entity. There is no guarantee of distribution payments from the operating corporation and these payments can vary with fluctuations in the underlying cash flow of the operating entity. Interest, generated from debt ownership and dividends resulting from equity ownership, are paid to the trust which in turn redistributes cash to


the unitholder. Distribution is not taxed at the trust level provided the trust meets certain distribution requirements. True leverage enters through the use of outside or third party debt. This debt is senior to internal debt and is generally held by banks in 2 to 3 year facilities. Some trusts roll this debt over through private placements with institutions with terms of 5 to 10 years. Third party debt increases unitholders’ risk. Generally, this debt is small in relation to the trust’s cash flow generated from operations. Thus, trust debt that impacts unitholders’ financial risk is third party and not internal debt. The operating company generates distributable cash flow which is equal to cash flow from operations (CFO) less sustaining capital expenditures. Sustaining capital expenditures are those needed to continue generation of the cash flow and are different from capital expenditures intended to finance growth. Actual cash flow distribution to the trust is a combination of interest, dividends and capital gains, which together comprise a return on capital, and a return of capital. The operating company generally does not pay out all distributable cash. It leaves a reserve as a buffer to smooth future distributions. The distributed cash flow is taxable to unitholders based on the form of income received by the trust. The return of capital element reduces the investor’s tax base and the investor pays a capital gain when units are sold. In essence, the return of capital element is a return of the original investment in the trust and this should be reflected in a reduction in the value of units. Return of capital distributions are most prevalent in the oil and gas trust area. At the operating level, management can either be internal to the company or accomplished by external management contracts. Some trusts have purchased external contracts to bring management within the operating company. Most newly formed trusts are using internal management structures. In some situations the trust purchases the rights to the trademark of the operating entity. In this situation the trust receives royalties from the company. An example is A&W Revenue Royalty Income Fund.

• Comparison with Limited Partnerships A Limited Partnership is a structure in which there is a set of limited partners with limited liability who are not permitted to have any control over the direction of the company, and a general partner with unlimited liability. In many cases the general partner is a corporation. Since this structure is a partnership, tax is only at the partner level thereby eliminating the corporate tax. One of the first Limited Partnership (LP) trust structures was Gaz Metropolitan. Subsequently, a number of other LPs were established in the Power and Pipeline area. The Limited Partnership provides a distribution which need not be equal to the partnership income. Partners are taxed on income, not on distribution. To the extent that distribution differs from income, the adjusted cost base of the investment is affected. In the Limited Partnership structure the adjusted cost base is equal to original cost of security plus the investor’s share of net income of the entity less the sum of the investor’s share of losses and actual distributions. Thus if the LP has no losses and distributes more than its net income, the adjusted cost base will increase. When investors sell their securities, they may be liable to a capital gain depending on the relationship of sale proceeds and adjusted cost base.


There are currently 6 LPs on the TSX. The LP structure was not used for business trusts even though it is a simpler structure. The reason relates to the fact that a LP is not considered Canadian property for an RSP. Hence it will have a tax impact in the retail and in some cases, the institutional market.

• Characteristics of firms that can use this structure As noted, the primary rationale for the establishment of a business trust and a resulting high unit valuation is delivery of a stable distribution to unitholders, which is a high proportion of operating company cash flow. While any company can organize itself as a business trust, in order to obtain the greatest benefit, the operating company should have a number of common characteristics. First and foremost the underlying cash flow at the operating level must be relatively stable. This requirement implies that the industry should not be cyclical, the company faces little existing or potential competition, the product is mature as is the market, there is a low level of fixed to variable costs and a low level of income elasticity. Companies with these characteristics typically can utilize large amounts of debt and while cash flows have some variability, it is not large. The second factor is a low need for new investment either to grow the company or to fund investments based on changing technological requirements. In order to maximize payout to unitholders, the operating company should have little expenditures beyond maintenance capital expenditures. This does not mean that growth is unavailable but generally it will be financed by secondary issues of units. Even though these secondary issues occur frequently for Oil and Gas trusts and REITs, they are less common for business trusts. Therefore, not all companies are candidates to use the business trust structure since the underlying business model may not lead to high and stable cash flows. And for those companies that have units outstanding, risks can and will be different. Of course, not all income trust forms will have the same stability in underlying cash flows; these differences will be reflected in the market price of trusts and in their distribution yield. For example, Oil and Gas trusts and REITs can have volatile cash flows. The former’s cash flows will depend on oil and natural gas prices which can be variable. REITs, although encompassing different businesses, generally will be sensitive to the overall economy. Thus, hotel REITs will be sensitive to tourist activity and are, in effect, a lease on a property that is renegotiated nightly. At the other end there are REITs that lease out office space where leases are longer term. Cash flows in the latter case will be more stable than in the former but cash flows still remain sensitive to the economy for both. Further, business trusts with their different operations can have different degrees of cash flow volatility. Trust risks will be reflected in unit prices. At the IPO stage, stability of expected cash flows is incorporated in price and in cash distribution yield (ratio of distributable cash to price). As the firm operates, its current distribution yield will reflect current risk of the entity.


With the success of the business trust model in Canada and use of the model by some U.S.-based companies listing units in Canada, it was only a matter of time until the structure made its way to the United States. A description of this security is provided in section 3.1.3.

• Distribution policy In the typical corporate structure found in Canada and the United States, management is concerned with stability of dividends. There is a hesitancy to reduce dividends per share once they have been increased since it is believed that a variable dividend stream will result in reduced share prices. This belief leads to dividend smoothing behaviour. Given that management increases dividends only when it believes that underlying cash flows can support higher dividends, dividend changes provide information to the market about management’s belief about future cash flows. In the standard corporation, where dividends are typically a small proportion of cash flows, there is sufficient slack for management to smooth dividends by retaining earnings in years with above normal cash flows and paying them out in lean years. The situation in an income trust is drastically different. While stability of dividends is important, there is little scope to smooth dividends in the event of a reduction in operating cash flow. The operating company can and does keep some cash in reserve and may use short term debt to pay dividends when cash flows are insufficient. However, this is not a viable long run strategy. An increase in cash retention can lead to potential problems associated with excess cash available to management. Use of short term debt will increase leverage and may generate associated problems of default and violation of restrictive covenants which can negatively affect the ability of the company to pay distributions. Also, the trust is not likely to reduce sustaining capital expenditures to fund any shortfall. The result is a strong link between cash flows and dividends. Since dividends and cash flows are closely related, there is not the same scope for information being provided by dividend changes. The raison d’etre of an income trust is to provide large and stable cash flows to unitholders. To achieve this result there are two important factors. First, companies using the income trust model must have appropriate business characteristics to provide stable cash flows. The second factor is distribution policy—how much of cash flow is actually paid out such that the firm can undertake needed capital expenditures while at the same time meeting the large distribution requirement? In order to evaluate these factors, consider the free cash flow to the unitholder (FCFU) of a business trust. This free cash flow is equivalent to free cash flow to equity measured in a traditional equity structure. It is the FCFU that should be used in the valuation of a business trust; this is the basis for distributions to unitholders. FCFU is defined as follows: FCFU= EBITDA – Interest (on third party debt) -Taxes- CAPEX (sustaining)-CAPEX (growth) +/- change in NWC +/- change in net third party debt Where

• EBITDA is earnings before interest, taxes, depreciation and amortization; • Taxes are actual taxes paid, which may be close to zero through deduction of interest

payments on internal debt and depreciation charges;


• CAPEX refers to capital expenditures: ‘sustaining’ are intended to maintain existing operation and ‘growth’ refers to investments to expand operations;

• NWC is net working capital.3 Variability of the FCFU depends primarily upon variability of EBITDA which in turn depends upon company business characteristics. For example, mature companies whose products have little competition, strong brand loyalty, little growth, a diversified customer base, little sensitivity to the economic cycle and very little technological change will have relatively stable EBITDA. The size of FCFU depends upon EBITDA level, but it will also be affected by factors such as capital expenditures for both growth and maintenance. In order to maximize cash flow to generate the greatest distribution, the firm should have little or no growth CAPEX and modest amounts of sustaining CAPEX. In fact, this need to minimize sustaining CAPEX has been a source of concern to investors since it is possible that distributions would be made at the expense of maintaining the firm’s assets. Note that it is not necessary that maintenance CAPEX be small but only that it be small relative to the EBITDA. For example a telecommunications company may have large maintenance cash flows but the size and stability of EBITDA would still make it a possible candidate for an income trust structure. Under this approach, growth comes from issuing new units and not from retention of cash flows. Note that FCFU can be increased by issuance of third party debt but this increases unitholders’ risk. As an example of the role of growth capital expenditures in distributions, Penn West Petroleum Ltd. originally rejected a conversion to an income trust arguing that the company had significant opportunities for growth that could not be accommodated under the income trust structure. Speculation that the company would convert to an income trust structure had increased company stock price prior to the company’s announcement.4 When valuing an income trust, expected FCFU should be used. Note that FCFU along with EBITDA are not GAAP defined variables. This could be a source of concern for some investors. In reporting company operational results and the base from which distributions can be made, income trust management uses the concept of ‘distributable cash’. While there is no generally accepted definition and it is not defined under GAAP, there is some commonality in use among business trusts. It is often defined as EBITDA less the sum of interest on third party debt, actual taxes paid and sustaining capital expenditures. In some trusts a deduction is made for a reserve for future distributions. There appears to be a fixation in the market on distributable cash since it is often used as the base from which distributions can be made, even though true cash flow is the FCFU. Also at the IPO stage a commonly used multiple is the ratio of price to distributable cash flow along with an estimate of the business trust’s distributable cash flow. Based on this fixation, any 3 In this example we are making no distinction between depreciation for tax and book purposes. Since we are interested in the former as it reflects the true cash impact, an adjustment would be required. 4Brent Jang, ‘Penn West rejects option of converting into trust’ Report on Business, Globe and Mail, November 21, 2003. PennWest Petroleum Limited is contemplating a new structure in which it is possible that a subset of assets will go into a trust and the remainder could become a junior energy company with the more risky exploration activity. This speculation began in January 2004 with the share price of $50 and as of August 17, 2004 the price was $64.50. With the large increase in oil prices, it is possible that this increase is not all related to the possible conversion to a trust. On August 20, 2004 Penn West announced that it would convert to a trust pending CCRA approvals. The stock closed on that day at $65.42. If approved, it is anticipated that this trust will be the largest income trust, exceeding the market values of Yellow Pages and Canadian Oil Sands.


increase in distributable cash is considered to be good. Thus if expenditures are reported as growth capital expenditures when they correctly are sustaining capital expenditures, distributable cash is incorrectly increased.5 If the FCFU approach is used, impact of this mis-categorization is eliminated. An investor evaluating a trust must look beyond distributable cash flow and consider FCFU. For example, FCFU will identify if a trust is funding its distributions from the issue of new third party debt, a potentially serious problem. However, as we will observe later, there is a relationship between distributable cash flow and FCFU. Fluctuations in FCFU can lead ultimately to fluctuations in distributions. For small short run changes in FCFU, distributions can be maintained by having the trust borrow to pay the full distribution. There can be problems with this approach if the change in cash flows long term and the trust increases its leverage ratio. For longer term shifts in cash flow due to economic conditions or firm or industry specific events, distributions can be reduced or even eliminated. Examples of companies that have reduced distributions include Atlas Cold Storage, General Donlee Advanced Fiber Technologies Income Fund and Heating Oil Partners Income Fund among others.

3.1 Benefits of the Trust Structure There are a number of benefits to the income trust structure. While many commentators look only at the tax efficiency element of the structure other benefits do exist. These include forcing companies to be more effective in their investment policy, reducing financial distress costs in the event that corporate cash flows are insufficient to meet interest payments on internal debt, providing an exit strategy for venture capital and for controlling shareholders and improving pricing of the security by returning to the capital market to raise capital. We consider each of these benefits in this section.

3.1.1 Tax Efficiency

Under existing income tax legislation, investors in corporate shares face double taxation either on dividend distributions or on retentions when shares are sold. The first level of tax is corporate tax applied to before-tax net income and the second level is tax on dividends in the hands of investors or a capital gain. The income trust structure, including limited partnerships, eliminates this double taxation eliminating corporate tax at the corporate level through use of internal debt and leaving tax in the hands of the unitholder. The operating company in a business trust generates distributable cash flow which is equal to cash flow from operations net of interest payments on third party debt (CFO) less sustaining capital expenditures. Actual cash flow distribution to the trust and ultimately to the unitholder is a combination of interest, dividends, capital gains and a return of capital. The first three elements are returns on capital. The operating company need not pay out all distributable cash, thus leaving a reserve as a buffer to smooth future distributions. Distributed cash flow is taxable to unitholders based on the form of income received by the trust. The return of capital element reduces the tax base and the investor pays a capital gain when units are sold. The return of capital arises when the 5 This reporting problem was observed in a number of articles about Atlas Cold Storage. See Steven Chase, “Atlas says profit overstated”, Report on Business, Globe and Mail, September 1, 2003


distribution to the trust exceeds the operating company’s net income. In essence, the company is returning part of the investor’s investment and this should be reflected in a reduction of share price. Return of capital distributions are more prevalent in the energy based Oil and Gas trust area. However, other trust types will have return of capital elements as well. For example, a Power Trust will have large capital cost allowance amounts as a result of large expenditures. To demonstrate the impact of double taxation and the benefit of the trust structure through introduction of single entity taxation we present a simple example. Assume that the corporate tax rate is 39%, the tax rate on personal income, applicable to interest income, is 46%, the effective tax rate on dividends is 31% and the effective tax rate on capital gains is 23%.6 Now consider $1 of before-tax net operating income in a corporation. The corporation pays corporate tax. leaving $0.61 available to shareholders. If the company pays this amount out to investors as dividends, the after-tax amount available is $0.61*(1-.31) or $0.42. This amount is found in table 3 below. If the company retains earnings and the investor sells the shares there is a capital gain, and the after-tax amount available to the shareholder is $0.47 assuming that the stock is sold at the end of the year.7

Table 3: Tax Gain per $ of Before Tax Net Operating Income Retail Investor Institution/RRSP

After-tax cash flow to: Dividends Capital Gains Shareholder $0.42 $0.47 $0.61 Unitholder $0.54 $0.54 $1.00 Net Gain from Trust form $0.12 $0.07 $0.39

However, let us assume that there is a Business Trust form for the company. Here the trust has issued a sufficient amount of internal debt so that there is no corporate tax. If distributed cash is equal to interest payments, the unitholder ultimately must pay tax on the full amount of the net operating income at the personal tax rate of 46%. The after personal tax amount available to the unitholder is $0.54. Thus, the gain to the trust structure ranges from $0.07 to $0.12 per dollar of before-tax net operating income.8 Then again, in some situations the investor is not taxable, or more correctly tax is deferred to a later period. This situation arises for institutional investors and those who invest in a RSP. Here, the shareholder or unitholder does not pay any personal tax, and the gain from the trust form is greater at $0.39 per dollar of before-tax net operating income. Although the business trust market is primarily retail, in recent years institutions have become more involved. Also, even for the retail market, we do not know the relative importance of RSP compared to taxable holdings. The net result is that although there is a tax benefit from the trust structure, it is difficult to determine a priori its exact size due to possible different tax rates based on the identity of the marginal investor.

6 These tax rates on dividends, regular income and capital gains are theoretical average values and the corporate rate is for an Ontario corporation. 7 If the investor does not sell the shares at the end of the period but defers the tax payment, the present value of the tax paid on the retention is less than the noted value. If there were no tax on capital gains the after tax amount would be $0.61 per dollar of income available to equity. 8 For a Limited Partnership, since income is not taxable in the partnership but in the hands of the investors, the first level of taxation is missing and the gains for the LP arise without the use of internal debt.


Whatever the ultimate amount of benefit, to whom does it accrue? Consider first the case where an existing company converts its structure to a business trust.9 The value of existing shares will increase to reflect, at a minimum, the tax benefits of the trust structure. New unitholders will purchase units at a price that incorporates expected tax benefits based on expected cash flows. If cash flows evolve as expected, gains from the trust structure accrue to the corporation’s original shareholders. New unitholders gain over time only if cash flows are greater than expected. A second example is the formation of a business trust from a formerly private entity. Here original shareholders end up with a unit value that reflects expected tax benefits. New unitholders, although facing lower personal taxes than they would under the standard corporate form, still pay a price that reflects this benefit. Therefore in the formation of a business trust, the original owners gain from the tax benefit and this gain is ultimately taxable in their hands. New unitholders, while receiving tax advantaged cash flows pay for this benefit.

3.1.2 Agency cost of ‘free cash flow’

The second benefit of the business trust structure is removal of the ‘agency cost’ of free cash flow; in this context free cash flow: is defined as the amount of cash flow available to the firm after it undertakes all good investment projects. To the extent that non-trust companies have large and stable cash flows and few growth needs for capital, cash flows in excess of the company’s maintenance (replacement) capital expenditures can be held in (unprofitable) cash (and marketable securities) or invested in projects that do not increase and may, in fact, reduce shareholder value. These latter projects may increase the amount of assets held by the firm but do not generate returns above the firm’s cost of capital. This type of behaviour and expectations that management, who can be thought of as shareholders’ agents, will continue in these value-reducing activities has a negative impact on the firm’s stock price. This problem is exacerbated by the current personal and corporate tax structure where it is in the firm’s best interest to retain funds and not pay them as dividends since tax on capital gains is less than that on dividends. Using the theoretical tax rates in the previous section, the gain per dollar of pre-tax income available to shareholders is $0.05. While this value does not appear large, to the extent that capital gains taxes can be deferred, the gain becomes larger. This ‘gold plating’ behaviour is diminished drastically in the income trust structure for two reasons. First, with the necessity to pay large and stable distributions under the trust structure in order to maintain unit values, management will not engage in cash reducing activities because they will reduce distributions to shareholders and thus unit prices. Further, since there is very little margin for error compared with a non-trust structure, management will be conscious of operational efficiencies. Second, in order to grow, the company will have to issue more units since all but maintenance expenditures have been paid to unitholders. Each time the firm goes to the capital market to issue new units, it faces increased scrutiny and the expectation of this scrutiny will reduce current cash flow waste. The business trust structure introduces a discipline in spending funds, and removes operating inefficiencies,resulting in a value increase. Cash is paid out to investors instead of invested

9 We analyze conversion in more depth in section 4.2.


in poor projects or held.. Operations become more efficient in order to generate increased cash flows.

3.1.3 Financial Distress costs

The third benefit of the business trust structure is a reduction in costs associated with financial distress. In a typical corporation structure, distress costs can arise when the firm has trouble meeting debt servicing obligations due to a cash flow reduction. Further, attempts to resolve distress also have negative impacts on the firm’s ongoing cash flow as management’s time and energy are shifted towards avoiding the impending distress event and away from running the firm. In the business trust structure, since both debt (other than external debt) and equity are owned by the same investors, an unexpected reduction in cash flows and a resulting inability to make a full interest payment on internal debt will not necessarily trigger financial distress since the unitholder (i.e. debtholder/shareholder) will immediately agree to a reduction in interest payments in line with lowered cash flows. Under this scenario, the company can handle larger amounts of internal debt needed to eliminate corporate tax at the operating level. Of course, the amount of third party debt has to be considered since this debt is senior to other outstanding securities issued by the company and the company can be in default if these debt obligations are not met. In fact, a number of trusts have had to reduce distributions due to negative operational impacts on cash flows. These reductions were undertaken without distress issues that could have occurred in a typical corporation with high levels of debt. Business trusts provide an interesting analogue to the high leveraged transactions market in the 1980s. Many companies, including poorly performing ones, were restructured, usually as the result of a hostile takeover or through a going private transaction, such that a large amount of debt was introduced into the capital structure. The purpose of debt was to eliminate the agency cost of free cash flow since management had to make interest payments or the firm was in default and management could be out of a job. Debt was intended to align management’s and shareholders’ interests and to provide a discipline to management activities. This discipline is more binding than the need to distribute a major amount of cash flow under the trust structure. However, the high leverage transaction had the problem of financial distress costs since in the event the company was unable to make interest and/or principal payments, the firm had to engage in frequently arduous negotiations with debtholders—a negotiation that is not needed in the trust structure. It is interesting to compare the Canadian business trust structure to that being used in the U.S. Equivalent securities in the U.S. are called either Income Deposit Securities (IDS) or Enhanced Income Securities (EIS). Due to U.S. tax legislation, debt and equity have to be marketable in the sense that there are separate values for each. Thus ‘internal’ debt and equity securities are clipped together and are potentially separate pieces. There is no trust in the U.S. structure. In revised structures there will be some debt (at least ten percent of the debt component) that is issued independent of the unit.10 The IDS is listed on an exchange and underlying securities, when unclipped, can be traded separately. To the extent that debt and equity are ultimately held by different investors, if there is a cash flow problem that impacts operating cash flow, bondholders may not be prepared to accept a reduction in interest payments as readily as if they were also equityholders. Thus the potential for financial distress is much higher in the U.S. structure compared

10 These bonds are called bachelor bonds.


to the Canadian one. The U.S. structure, in essence, begins to look more like the high levered transaction structure. One issue is currently outstanding at the SEC with 17 new issues delayed. The SEC is holding up the issues because it wants companies to forecast future dividends from projected earnings but companies are reluctant to do so for fear of investor lawsuits if forecasts are incorrect.

3.1.4 Facilitating Venture Capital Exits and Restructuring strategies

In the venture capital area, providers of funds have an expectation of a profitable exit within a reasonable time period. Whereas there are many exit forms in a venture capital context, preferred choices are a buyout and an IPO. The need for potential liquidity of a venture capital investment is very important. To the extent that ability to exit profitably from a venture is increased, there will be more venture capital investments. When the business trust IPO is used as an exit, it is applicable only to a subset of companies—those that have operating characteristics consistent with a business trust. Hence, lower risk, lower growth companies are more likely to use this exit route. These companies include large infrastructure investments in which large public sector pension funds are typically a partner in the venture financing. An important benefit to these venture capital exits is that venture capitalists can redirect funds to new promising investments and as well, the IPO adds new securities that are traded in the market. These new securities increase investors’ ability to diversify, generate distribution patterns preferred by some investors and permit market discipline of managers. In some situations the new securities allow firms to grow by having access to capital markets. There is no question that making exits easier and more profitable will increase the number of these venture investments. The business trust structure with its use of internal debt to reduce taxes paid, increase the after tax cash flow, and ultimately exit price, will lead to more investments. Even though the types of investments are of lower risk and growth, this is not a negative aspect since infrastructure investments are an example of needed investments. In a private company there is usually a founding shareholder or family that has a controlling interest in the company. Generally these investors have a significant amount of wealth tied up in the firm. In order to increase personal consumption, facilitate a change in management or diversify investments, controlling shareholders will use an IPO in which holdings are reduced and in some situations managerial responsibilities are relinquished11 Wealth is created because the investment decisions made by the new management or the existing management who now have lower share holdings are improved. They do not have all of their wealth tied up in the company. Additional benefits arise from capital market oversight and the introduction of a new security to the capital markets. Another type of exit is a restructuring of an ongoing company where a division is sold off in an IPO or assets are sold to a trust. In this type of restructuring, certain assets become part of the trust and remaining assets are managed in a typical structure. In these restructurings, two new securities are substituted for the original security. Financial research has observed an increase in share value in the

11 A current example is the Brick IPO where the founder wants to cash in part of his stake in the company and step down as CEO.


context of spin offs and sell offs in a non-trust structure. The presence of a trust will increase values due to other benefits of a trust. The last type of transaction is a conversion of an existing publicly traded company to a trust structure. Conversions are associated with an increase in payout policy and reduced growth which can increase shareholders’ wealth.

3.1.5 Efficiency of Market

With the need to pay out significant distributions to unitholders, ability to finance growth through retentions is curtailed. In Oil and Gas trusts, distributions are composed of a significant return of capital to reflect the wasting nature of assets of the trust. In order to grow, these trusts must issue new units and/or other forms of capital such as convertible debt. For business trusts, returns of capital are a much smaller proportion of overall distributions; in order to grow, new units have to be issued. This capital raising highlights the firm’s operations and capital market participants can review company operations and its value. The need to raise outside capital assists investors in monitoring the trusts and leads to more efficient markets.

3.2 Potential Issues

3.2.1 Tax losses to government

Given current tax law, unitholders are in a better position from an after tax perspective through the trust structure rather than a structure in which more of the payment is through dividends rather than interest. This gain to unitholders is a current loss to Government coffers. Tax loss, also called tax leakage, is even larger when the unitholder is an entity such as a pension fund or an investor holding a retirement savings plan where there are no current taxes on all forms of income; however, for these entities, taxes are deferred and paid when the beneficiary or investor receives payments from the fund. Note, it is possible that including future taxes payable by investors, there may be no loss or a small tax loss to the government from a present value perspective. Research is undecided on the size of this tax loss but when future taxes are taken into consideration, it appears that the loss is not large and under certain situations can even be an increase in tax revenue.12 It seems that the major concern of the Government is possible conversion of large corporations to the business trust structure. However, when a conversion occurs there is a tax liability generated for existing shareholders as share price increases and taxes will be paid as shares are sold. It is also suggested that the tax impact of trusts will increase the rate of return on investments undertaken by firms and lead to non-economic investments being undertaken.13 Note that this argument is used most frequently in the context of business trusts. This argument is not persuasive. Business trusts use the trust structure because they do not intend to grow through new investments.

12 See section 5.2 for references to the research and a discussion of some of the issues facing the Government. 13 This argument is often stated in terms of a reduction in the cost of capital facing trusts. However, whichever way it is presented the implications are the same.


Capital expenditures are undertaken to maintain assets. As we demonstrate later, it is Oil and Gas primarily and REITs that use new equity issues to fund new growth. There may be some business trusts that issue new equity for growth but they are the exception.

3.2.2 Impact of third party debt and ultimate default

As in any equity security, income trusts present potential problems for investors. With the focus on size and stability of distributions and the low margin of error to maintain distributions when cash flows are inadequate, some problems facing income trust investors are more serious than for regular equities, although for most problems it is a matter of degree. Even though financial distress costs are lower for business trusts, there are still variability problems in cash flow and true distress/default where third party debt is in the capital structure. Third party debt is ‘hard’ debt and failure to pay this debt can lead to default. Third party leverage has the potential for disruption of cash distributions, even if cash is available, due to the triggering of a covenant that restricts payment of distributions. It is important that investors understand constraints imposed by third party debt and the size of this debt in the capital structure. However, too much can be made of the third party debt issue and potential default. In the business trust sector, firms will chose capital structures reflecting the underlying risk of cash flows. The same concern with third party debt is found in other trust structures. In order to assess the third party debt issue we look at two debt ratios for Business, Power and Pipeline and Oil and Gas trusts in Table 4. One ratio relates to the amount of debt—the ratio of Debt to Enterprise value and the second ratio relates to the ability to service debt—the interest coverage ratio. Data is provided by BMO Nesbitt Burns for 2002 and 2003. The first observation is that for all trust types, amount of third party debt is conservative. The lowest ratio for debt/enterprise value is in the Oil and Gas area, which has the riskiest cash flows; the highest is in the Power and Pipeline area for which cash flows are the least risky. For Business trusts in 2002 and Power and Pipeline trusts for both years, the weighted average is greater than the simple average suggesting that larger firms, which generally have lower risk, have higher debt ratios. Looking at interest coverage, values are quite high given that cash flows, certainly for Business and Power and Pipeline trusts, are not highly variable. Interest coverage ratios fell from 2002 in Business and Power and Pipeline trusts whereas Oil and Gas trusts, following strong commodity prices, had an increase in coverage.


Table 4 : Debt Ratios for Business, Power and Pipeline and Oil and Gas Trusts

2002-2003 Debt/Enterprise value Interest coverage ratio 2002 2003 2002 2003 Business Simple average 21% 20% 9.9 X 6.4 X Weighted average 26% 20% 6.9 X 7.3 X Power and Pipeline Simple average 25% 29% 15.5 X 5.6 X Weighted average 30% 33% 13.6 X 6.3 X Oil and Gas Simple average 19% 15% 5.4 X 14.7 X Weighted average 18% 13% 4.5 X 12.4 X Source: BMO Nesbitt Burns

Overall existence of third party debt is an important element but trusts have not increased this debt amount to seriously high levels.

3.2.3 Inappropriate companies using the structure

One issue unique to income trusts, especially business trusts, is the consistency of the business model of the company with the income trust feature of stable cash flow and distributions. As noted previously, the business model appropriate for income trusts requires stable cash flows and little retention of cash flow for non-maintenance capital expenditures. In fact, growth in the trust typically is financed by issuance of new units. Considering the business trust segment, certain firm characteristics are ideal for income trust structures since they lead to stable cash flows. These characteristics include a low ratio of fixed to variable costs, a mature company, little competition, little or no technological change, limited capital expenditures, products with strong consumer loyalty and a low sensitivity to the business cycle—non-cyclical cash flows. In fact, there are companies that have considered the business trust structure and rejected it due to either inappropriate business characteristics or the need for substantial investment dollars to finance growth. As demand for income trusts increased at both the retail and institutional investor levels, companies considering the income trust structure may not have the ideal characteristics. Underwriters, observing demand for these securities, might bring an inappropriate business to the IPO stage as an income trust. This scenario was observed in the late 1980s high leverage transaction market where an overheated U.S. takeover market led to companies with inappropriate business characteristics engaging in these transactions. Of course, this behaviour had impacts on the ultimate success of the market and the underwriters’ reputation. With a strong mutual fund/pension fund interest in income trusts, poorer quality issues will receive a poor reception in the market and either unit prices will be adjusted or the issue will be pulled. Note, however, that potential problems with inappropriate companies using the trust structure is no different from any equity security issuance—in hot issue markets many poorer quality equity issues will be sold. This situation in the business trust sector reinforces the point that investors should understand the business model underlying the trust and price the securities appropriately.


3.2.4 Governance Issues

The governance of business trust structures, which at first glance appears to differ from that of regular corporations, has given pause to some financial analysts, commentators and the investing public about the risk and valuation of business trust structures in general, and their suitability for inclusion in the TSX/S&P market index in particular. From our analysis of advantages and disadvantages of governance in business trusts, we conclude that governance on balance is not an important differentiating factor for business trusts relative to regular corporations. This conclusion is based not only on governance of trusts through trust declarations but also on the importance of securities regulation, listing standards and good governance discipline induced by the implicit requirement to pay a substantial portion of cash flows as distributions to unitholders. This conclusion does not imply that there are no differences or that they can be unimportant but only that trusts operating to maximize and stabilize their distributions and share price will behave appropriately.14 Corporate governance is the system by which business corporations are directed and controlled. This structure specifies the distribution of rights and responsibilities among the corporation’s different participants, such as, the board, managers, shareholders and other stakeholders and spells out rules and procedures for making decisions on corporate affairs.15 A Business trust is subject to a set of regulations and requirements. It operates under a declaration of trust which sets out the trust’s terms, securities law regulations in provinces in which it has distributed units and an exchange’s listing requirements if it has listed units. Since the second and third sets of regulations are the same for securities of normal corporate structures and units of Business trusts, any governance differences between trusts and normal corporations will arise from differences in specific provisions in the declaration of trust and the relevant Corporations Act affecting corporations with a typical corporate structure. Moreover, commentators have suggested that securities law and listing requirements are more important in the governance area than the respective Corporations Acts affecting corporations and the declarations of trust. In a careful analysis of governance features for a business trust relative to a standard corporate structure, Mark Gillen16 observed that declarations of trust for business trusts are structured to largely replicate provisions of corporate statutes such as the Canadian Business Corporations Act (CBCA). Trust law was intended to protect beneficiaries of estate planning trusts. However, since it is flexible, its provisions could and have been drafted to protect the trust’s unitholders. Note however, it is not mandatory to replicate shareholders rights in the trust instrument. A complicating factor in the Business trust structure is that there are two tiers in the structure—the first is the trust level for which units have been issued and trustees represent the unitholders’ interests; the second tier is the operating level where the trust owns the equity of the operating entity 14 The Province of Alberta has issued a discussion paper on the Governance issue. See http://www.revenue.gov.ab/publications/2004_0728_income_trusts_discussion_paper.pdf 15 This definition is based on the OECD definition in April 1999. 16 “A Comparison of Business Income Trust Governance and Corporate Governance: Is there a need for Legislation of Further Regulation”, 2003, paper presented at the Capital Market Institute conference on Income Trusts.


and where there are managers and for which unitholder control is indirect. Thus for Business trusts, unitholders have either direct or indirect control over both tiers. However, there are exceptional circumstances in which there is neither direct nor indirect control of the operating entity. An example, noted by Gillen, is A&W Revenue Royalties Income Fund. Also there are some situations in which there is a management contract with the operating company which could impact control by trustees over equity interests of the operating entity. Here there was a separate management, sometimes owning trust units, but being compensated on the basis of a management contract. There have been some instances of contracts that either were poorly drafted or gave incorrect incentives to management. Many income trusts have internalized these contracts and new trusts are generally established with internal management.17 To the extent that these situations are important and negatively affect governance of the entity, the market should price this factor and yields on the units should be higher. Gillen notes that there are some features of the CBCA that are not replicated in trust structures. These include shareholder proposals and the appraisal remedy. At the trust level, derivative actions and the oppression remedy are not available. As Gillen notes, derivative actions in the corporate context have been dealt with under the oppression remedy but the oppression remedy is not available in the trust structure. With the flexible nature of trust legislation, we would expect that trusts would choose that set of corporate statue provisions that maximize value of units. Thus it is possible that lack of appraisal rights and oppression remedy may, in fact, be in the best interests of unitholders. Note that both provisions are not available for U.S. equities. Given that trusts have publicly traded securities, sale of securities may be the appropriate solution to oppression or appraisal problems. As described above, there are many similarities between trusts and regular equities in the areas generally considered to be related to corporate governance. But just as important is that governance and the impact of corporate behaviour on shareholders is now being affected generally by both securities regulation and listing standards of exchanges. Since trust and non-trust entities are influenced by both elements, any differences in governance are minimized. Finally, it is surprising that some investors rail against trusts due to poor governance yet dual class share structures which provide equally thorny governance issues are either ignored or if concern is expressed, there is little hesitancy to purchase shares.

3.3 Attributes for investors Having observed large growth and continued interest in income trusts in general and business trusts in particular, it is apparent that investors find them attractive investments. Institutional (pension fund) investors have invested in REITs and oil and gas trusts for many years since trust structures were pervasive in these industries. Similarly, retail investors also held these securities. Growth in business trusts, in the beginning, was in the retail investor market, including income trust based 17 Management contracts per se need not be bad. For a small income trust, access to strong management may require an external manager since full time internal management may be too expensive. However, the important issue is to structure the contract so that management has to incentive to increase unit value and not just size of the trust. Also any bonus scheme based on distributions should be structured so that the bonus is related to more current distributions and not distributions that were initiated when the trust had its initial public offering.


mutual funds catering to retail investors. However, pension funds have also been increasing investments in business trusts even though there is concern about unlimited liability.18 We next consider why each of these investor classes might find these investments useful. Of course, one important aspect of these securities which all investor classes find valuable is high payout of cash flows and hence reduced incentive by corporations to make non-value increasing investments.

3.3.1 Retail investors

Retail investors have different needs for cash flow from investments and are prepared to take different risks. The income trust market satisfies a subset of the retail market. This subset includes investors who value income over growth and hence want to see high distributions. These investors may possibly include retired individuals or those who want to introduce less risky investments into their portfolio. The aftermath of the 2000-2001 large market decline also reinforced the desire for stocks with high distributions. The buoyant market reflected high growth by a number of companies and industries and investors appear to have an aversion to these types of companies. By paying out a large proportion of the cash flow, trusts are unable to reinvest into value reducing projects. Another use that retail investors have for trusts is the capital gain element that occurs when distribution has a return of capital component. Investors who place investments in tax deferred accounts (RSPs) do not obtain this benefit. This gain may be overemphasized since the price paid for a trust will reflect its distribution policy, including return of capital. However, one benefit of trusts with large return of capital distributions is that capital gains can offset some capital losses incurred during the 2000-2001 market decline. When trusts were originally sold, emphasis to the retail investor was distribution yield size and their pseudo-fixed income characteristics. In fact, use of the term ‘yield’, although for certain trusts it is related to expected rate of return and risk, continues to link trusts to fixed income securities. As business trust investors have learned, there is some risk to business trusts and distributions are not fixed; they can and have been reduced or eliminated.

3.3.2 Pension Funds

There are a number of reasons for pension funds to invest in income trusts including business trusts. In order to appreciate their interest in this security class, we present a short digression on pension funds. Defined benefits19 pension funds have a set of liabilities which are equal to beneficiaries’ future payments. Mature companies have a large number of retired beneficiaries and thus have specific cash flow needs. Younger companies have less immediate cash flow needs but have growing liabilities as the work force ages. One important aspect of these liabilities is that valuation is similar to that of bonds and thus when interest rates fall current value increases.

18 Some pension funds have established special purpose corporations into which they place their income trust investments, thereby immunizing their other investments from unlimited liability of business trusts. 19 A defined benefits pension fund makes a promise to pay a pension to its beneficiaries based on a specified formula usually based on the number of years of work and some contractually defined salary when the beneficiary retires.


In order to fund these liabilities the company makes contributions (in some cases jointly with employees) in order to build a portfolio of assets that will be sufficient to pay retirement claims. The asset portfolio is generally composed of debt and equity investments. We look at the asset side first. Income trusts and particularly business trusts have a low correlation with the overall market and lower variability (as measured by standard deviation) and thus can be used to diversify the portfolio and reduce its risk. In Table 5 below we present the correlation of monthly rates of return on various indexes, including bonds and stocks from 1996 to June 2004. We also present the annual standard deviation for each series. As can be observed in the table, correlation of business trusts is highest, at 76%, with REITs and lowest with the TSX index (41%). Considering the trust composite index, correlation with the bond market is 44% and with equities, 54%. Further, looking at standard deviations of specific trusts, the business trust index has the lowest value (13.9%) and oil and gas, the highest (20.6%). Standard deviation of the composite is the lowest since it is a portfolio of three trust types and lower risk is a result of diversification. Building a portfolio of trusts, most likely a portfolio of all trust types, will result in lower risk.

Table 5: Correlation Coefficients for Trust Types and Composite and Annual Standard Deviations

Trust

Composite Business

Trusts Oil and

Gas REIT Bonds Standard

Deviation* Composite 13.3% Business Trusts 0.92 13.9% Oil and Gas 0.85 0.63 20.6% REIT 0.81 0.76 0.52 15.6% Bond 0.44 0.48 0.32 0.42 TSX Index 0.54 0.41 0.50 0.51 0.15 18.0% * estimate based on annual data

In addition, trust investments are useful when considering liabilities. First, with their high cash distributions, income trusts can be helpful to a mature plan that has large cash flow needs. Second, trusts provide a good hedge against value changes in liabilities with respect to interest rate changes. Pension fund liabilities react to interest rates like bonds and a high correlation of bonds and a trust index will provide a good hedge. With a 15% correlation, equities do not provide a good hedge to liabilities. However, the correlation with bond returns of 48% for business trusts and 44% for the trust composite suggest that there are some hedging benefits. Thus if interest rates fall, liabilities increase in value but as we have seen, so also do trust values. At the same time as we have discussed the importance of portfolio construction and use of trusts for hedging in an institutional perspective, the arguments are also applicable at the retail level. Thus mutual funds that provide a portfolio of income trusts, which is a diversified portfolio, can be combined with equities and bonds to determine the investors’ desired portfolio reflecting risk and cash flow characteristics.


4.0 What we know about the financial instruments and companies using them? To this point we have discussed issues surrounding trusts at a high level. In this section, we focus more closely on various trust types considering first how they become trusts, either through an initial public offering or a conversion from a normal structure. We then look at trusts that are currently in public markets and measure their performance and the sensitivity of their rates of return to economic factors such as interest rates and the general economy. We also observe whether or not trusts, in aggregate, have been over or under priced in the market. We also investigate in some depth the follow-on financing activity of the various trust types and observe differences among trusts.

4.1 Initial Public Offerings

• Is pricing different from IPOs of non-trust structures? Just as any equity initial public offering (IPO), the value of a trust IPO is equal to the present value of expected cash flows from the financial instrument and a discount rate, which reflects risk of the entity being valued. A full valuation would require forecasting expected cash flows based on an expected growth rate for a particular period and a normal level of growth for cash flows beyond that period. In many traditional company IPOs, a shortcut is used in which expected cash flows, frequently measured as earnings to common equity (or a cash flow to equity), are multiplied by a multiple that is derived from ‘comparable’ companies that are currently traded in the market. This multiple reflects risk and growth opportunities for comparable companies. To the extent that the IPO company has growth opportunities or risk that differs from the comparable companies, an adjustment to the multiple is made. The result of this calculation is an estimated equity value and adjusting by the number of securities issued determines the issue price.20 The procedure for a trust is not very different. The starting point is total expected distributable cash for the trust. Multiplying this amount by a multiple reflecting risk and growth in expected distributable cash of the trust, based on multiples from comparable trusts, generates a total value for trust units. One difference between a trust IPO and a regular IPO is that the issue price of the former is set at $10 per unit. Thus to obtain a $10 unit price requires determination of number of units to be issued. For example, suppose that total distributable cash flow is equal to $20 million. Underwriter(s) along with company management determine that the appropriate multiple for a company of its risk and growth opportunities is 15 times. This multiple corresponds to a distribution yield (distribution divided by price) of 6.67%. Market value of the entity based on distribution and multiple is $300 million. In order to obtain a $10 price, 30 million units need to be issued. 20 Consider the simple growth model where the security price is written as follows: P(1) = d(1)/(k-g) where d is the per share dividend, k is the cost of equity capital and g is the expected growth rate in dividends per share. If the retention rate (b) is expected to be constant, dividends can be written as d(1)=eps(1)*(1-b). Substituting into the price equation we obtain: P(1)=eps(1)*(1-b)/k-g and the multiple M=P(1)/eps(1)= (1-b)/(k-g). Note that the multiple will be greater if risk is lower (k is lower) or growth is higher. This conclusion assumes that for every dollar invested, the expected rate of return exceeds the cost of equity capital. If it is just equal to k, the multiple is equal to 1/k which reflects only risk. It is possible that g is negative if the company pays out a large amount of dividends and does not reinvest to maintain its assets.


If the multiple were to fall to 10 times (distribution yield rises to 10%), market value of the entity is $200 million and 20 million units need to be issued to obtain the $10 unit price. Note that under the lower multiple, expected distribution per unit is higher. It has been suggested that this form of valuation for trusts is flawed since it uses distributable cash flow and not earnings or cash flow and does not reflect the growth of distributable cash flows. This is not necessarily correct. To demonstrate the similarity, consider a business trust that has no expectation of growth and any capital expenditures will be dedicated to maintaining assets such that the company can generate cash flows. Free cash flow to a unitholder (FCFU), defined in Section 3.0, is presented below. FCFU= EBITDA – Interest (on third party debt) -Taxes- CAPEX (sustaining)-CAPEX (growth) +/- change in NWC +/- change in net third party debt Assuming the company does not change its net working capital and maintains the same external or third party debt level, FCFU equals EBITDA less Interest (on third party debt) less CAPEX(sustaining) which is the net income to the unitholder. Note that Taxes are equal to zero. But distributable cash flow is also equal to the same value. Apply a multiple to the distributable cash flow is the same as applying the multiple to net income as is done in the IPO for a non-trust firm.21 If the trust contemplates growth capital expenditures, they need to be financed either by retaining earnings or by issuing new units. In both cases, if future investments are expected to earn a rate of return in excess of cost of capital, the price will be higher for a given level of current distributable cash and the multiple will be higher. This is no different from a normal IPO. Finally, if the company intends to pay out some of its capital as a return of capital, this translates as a negative growth rate. The multiple will be lower reflecting the negative growth rate and the fact that if the firm follows through on its plans, the firm will disappear after a number of years. Distribution yields which are the reciprocal of the multiple, on average, differ across various income trust types and are shown in the following Table 6. Each average value is significantly different from zero. However, as observed in the standard deviations, there is variability within each trust type. Also, average values are significantly different from each other. Average values appear to represent average differences in risk—the riskiest entities are Oil and Gas Trusts and the least risky, power trusts. These observations are consistent with risk measured by sensitivity of rates of return on a trust type to macroeconomic factors. These sensitivities for Oil and Gas and REITs are presented in section 4.3.1.

21 In this example, the price of a unit is written as follows: P(0)=distributable cash flow/(k-g). However, the growth rate is zero and the multiple is P(0)/distributable cash flow=1/k. Thus if the cost of equity is 10%, the multiple is 10 times.


Table 6 : Issue Price Yield on Trust IPOs, 1995 to 2004(June)

Business Trusts

Power Trusts

Oil and Gas Trusts

REITs

Average 11.5% 9.5% 14.4% 9.9% Median 10.5% 11.5% 11.1% 10.6% High 16.3% 13.4% 32.5% 18.0% Low 7.2% 9.3% 9.3% 8.3% Standard Deviation 2.2% 1.2% 5.8% 2.2% Number 64 15 14 22 Source: CIBC World Markets

We also looked at impact of size and institutional holdings on issue price yield. We observed that issue price yield was negatively related to issue size and to institutional holdings. The former reflects the fact that larger firms are typically less risky and the latter shows that institutional investors either can have an impact on yield due to their negotiations or that they typically invest in less risky issues which have lower issue price yields (or higher multiples).

• Post issue stock performance In IPOs of non-trust entities issue price is set, the security is then issued and is available for trading on the market. A large amount of academic research has been done on post-IPO stock price performance comparing issue price with end of first day closing market price. To the extent that first day closing price is above issue price, the company has left some value ‘on the table’ since they could have issued the security at a higher price.22 In Table 7 below, there is a comparison of underpricing for TSX firm commitment offerings for the period 1997 to 1999 and offerings in various markets in the United States. Underpricing is defined as 100* (first closing price-issue price)/issue price and will be positive when stock price rises from the issue price after the issue.

Table 7: Underpricing by Exchange Exchange TSX AMEX NASDAQ NYSE Underpricing 12.02% 3.08% 43.19% 12.91% Source: information as reported in Kooli and Suret23 All values are statistically significant from zero at the 1% level.

As can be observed, underpricing on average occurs in all markets; considering U.S. markets, there appear to be differences with the largest underpricing occurring in NASDQ which would have the highest number of high growth, high risk firms and more likely smaller issue sizes. In fact Kooli and Suret show that underpricing decreases with an increase in issue size.

22 A current example is the Google IPO which had its issue price reduced to $85. The first day it traded it closed at $100.34, a rate of return of approximately 18%. Over the two days post issue the stock had a 27% rate of return. 23 M. Kooli and J-M Suret (2003), “How Cost Effective are Canadian IPO Markets”, Canadian Investment Review, Winter.


We calculated average underpricing for all trusts and by specific trust type to determine whether or not this market is different from that for non-trust companies. Average underpricing, defined the same way as Kooli and Suret, is found in Table 8 below.

Table 8: Average Underpricing by Trust Type Trust type Business

Trust Power Trust

Oil and Gas REIT

Underpricing 2.42%* 1.16% 3.68%* 3.29%* *statistically significant from zero at 1% level

While all but the Power Trust category has significant underpricing, underpricing is not statistically different between trust types. Also the amount of underpricing is quite small. This small amount likely is due to the fact that these firms are less risky and have fewer growth opportunities than IPOs of non-trusts; issuing shareholders do not leave as much on the table since they may be reducing their personal holdings in the firm. We also found that underpricing was greater for larger issues when we looked at all trusts and business trusts. This result may reflect the issue’s success and the fact that larger issues have more institutional interest and liquidity.

4.2 Conversions Many companies have become income trusts by converting from a standard corporate structure. As noted in an earlier section, there are many benefits that accrue to the trust structure that would make it more valuable as a trust compared to a standard corporate structure. Any increase in share value due to conversion will reflect not only the reduction/elimination of corporate income tax but also benefits derived from the need to pay large and stable distributions. These benefits include elimination of value destroying capital expenditures, improvements in cost containment and more effective management of the firm. Of course, not all firms will find conversions enhance shareholders’ wealth since firm characteristics must be consistent with trust structure constraints. We investigated impact of the first public announcement by companies that were reorganizing to a trust structure. Over the period January 2001 to July 2004 we observed 41 reorganization announcements, 15 in the oil and gas sector and 23 in business trusts.24 Adjusting for any market movements over the announcement event period covering the day of the announcement to the close on the day following the announcement, we calculated the cumulative abnormal rate of return on each trust type over three sample time periods relative to the announcement date. 25 We then averaged these cumulative abnormal returns for all trusts and for business and oil and gas trust separately over the sample periods.

24 There were some REIT conversions but the sample size is too small to do any analysis. 25 In order to remove the market influence, the relationship of the rates of return for each security and the TSX300 index was estimated from day -252 to -21 where 0 is the date of the announcement. Using this relationship, an abnormal return for day t is calculated as the actual return in day t less the return expected based on the actual return in the market for this day and the regression parameters. The pre-event period is from days -20 to -1 and the post event period is from days 2 to 32. For each of these periods, an average of the daily abnormal returns for each trust in the sample is calculated. For the event period, 0 to 1, the abnormal return is the sum of the two daily observations.


The cumulative abnormal return at the announcement date provides the market’s assessment of gains that should accrue from conversion to the trust structure. Note that there remains uncertainty whether the conversion will occur since this announcement concerns the company’s decision to consider the conversion. Thus the increase in share price will likely underestimate the full impact of the conversion. Further there may be situations in which there was a leak to the market about a possible conversion before the first public announcement. In this case measured gains are also too small. Results of this analysis are found in Table 9 below. In the table there are three entries for each trust sample. The first entry measures the cumulative abnormal return over 20 days prior to the announcement, the second entry, cumulative abnormal return for the announcement (event) period and the third entry, cumulative abnormal return subsequent to the announcement. Considering all trusts first, there was a 11.53% cumulative abnormal return on average that was statistically significantly different from 0. In pre-and post event periods, average cumulative abnormal return was not statistically different from zero. For business trusts, only the event period displayed a significant response at 12.78%. The pre-event period was not statistically significant although its size is large. This result can reflect a large variability in sizes of the cumulative abnormal returns for individual business trusts over the pre-event period. Looking at the range of reactions within the sample over the event period, the high value was 51% and the low, -7.9%. Results for the oil and gas trusts are similar to the business trusts except that the size of the pre-event cumulative abnormal return is much smaller and remains statistically insignificant. The event period abnormal return is 9.26% with a range in the sample of 66% to -13.4%.

Table 9: Average Abnormal Returns Over Sample Time Periods

Average Cumulative Abnormal Returns

Pre-event (20days) 5.09% All Trusts Event (2days) 11.53%* 41 firms Post Event (31 days) 1.88%

Pre-event (20days) 8.22%

Business Event (2days) 12.78%* 23 firms Post Event (31 days) -3.98%

Pre-event (20days) 1.83%

Oil and Gas Event (2days) 9.26%* 15 firms Post Event (31 days) -2.93% *statistically significant at the 5% level

To provide a visual depiction of results, we present a plot of daily average abnormal returns for the total trust sector for the period starting 250 days prior to the announcement to 32 days after the announcement. The average abnormal return for each date is found on vertical axis. The large positive spike represents large positive market reaction to the conversion announcement. Note that these stock price increases occur at the date of first public announcement and not when the actual


company reorganization is approved or when the new trust starts to trade. That is, market participants view reorganization as good news and this information is embedded in stock prices immediately. Figure 3: Cumulative abnormal returns for all trusts Time period ‘253’ is the announcement date.

-0.04

-0.02

0.00

0.02

0.04

0.06

0.08

0.10

232 253 285 We also estimated the gain in stock price for all trusts from two days after the conversion announcement to its ultimate consummation. The gain is measured as the rate of return over the specified period. Note that the time to consummation from the announcement date will differ for each conversion. For 41 trusts, the average return was 7.3%. Over corresponding periods, the average return on the market was -0.7%, leading to a market adjusted gain of approximately 8%. Therefore, over the combined period from just prior to the announcement to the actual conversion date, the market adjusted return was 8% plus 11.5% or 19.5%, on average. Is there any way to determine if the gains are due exclusively to the reduction/elimination of tax? If we make a number of simplifying, but not unreasonable assumptions, we can assess impact on stock prices from the tax effect as follows:26 Pu /Pe -1= TAX/FCFE where Pu is price per unit

Pe is price per share of equity prior to conversion TAX is actual taxes paid by the pre-conversion company FCFE is free cash flow to equity of the pre-conversion company

The left hand side of the equation is the percentage increase in share value due to the tax effect of the conversion. Thus if taxes are 10% of the pre-conversion firm FCFE, there should be a 10% tax-induced increase in share price associated with the conversion.

26 In deriving this expression we assume that the stock (unit) price can be written as the product of a multiple and the free cash flow to the equity (unit). We further assume that the multiple will not change due to the conversion. Also we are assuming that the free cash flow will not be affected by the conversion and the company’s debt equity ratio and working capital will not change.


However, there are situations where the firm was not taxable when the conversion decision was made but would be in a tax paying situation in the near future. In this case, forecasted taxes and FCFE would be needed to assess the tax impact. We estimated the tax effect variable for conversions for 25 companies that had sufficient tax and accounting data. For this set of companies, the abnormal return around the announcement date was 10.02% and the market adjusted return from just after the announcement date to the actual conversion was 6.2% leading to a total gain of approximately 16.2%.27 The average value of the tax variable for this set of companies was 12.8%. Since the gains in stock prices exceed the gain through the tax effect, the benefit from the tax effect is not the only explanation for the increase in the stock price of conversion companies. This analysis is preliminary and the results indicative of the impact. Further research on this specific topic including the appropriate way to measure the tax variable is warranted.

4.3 On-going companies

4.3.1 Performance, distributions and sensitivity of rates of return to economic factors

a. Performance Major elements of any financial security are its performance and risk. We assess these first by looking at monthly average rates of return on indexes of Business, Oil and Gas and REITs and a trust composite over the period January 1996 to June 30, 2004. Indexes are value weighted and prepared by BMO Nesbitt Burns. These indexes do not include all trusts yet are representative of aggregate performance since they include a substantial number of trusts.28 In the top half of Table 10 below, we measure rates of return with distributions reinvested, because distributions are an important contributor to the return from trusts. Average rates of return are highest for Oil and Gas Trusts (1.8% per month) and lowest for business trusts. However, higher returns come at a price in terms of risk since the standard deviation is also the highest for Oil and Gas and lowest for Business Trusts. Risk is also observed in maximum and minimum monthly rates of return where the largest range is found for oil and gas trusts and lowest for business trusts. Further, the average monthly rate of return on the TSX composite is lower than the average rate of return on all trust types and the standard deviation is higher for all trust types except oil and gas trusts.

27 The return from post conversion announcement to actual conversion date was 7.9% and the market rate of return was 1.7%. We have subtracted the full market impact but this is unlikely true since these companies are likely to have a sensitivity to the market of less than unity. Thus the estimate of the post announcement adjusted return is biased downward. 28 To the extent that BMO Nesbitt Burns does not follow the smaller and riskier business trusts, there may be a small bias in the results.


In the second part of Table 10 we use monthly rates of return without reinvestment of distributions to assess performance. In any comparison, including reinvested dividends with the trust indexes will bias any results towards superior performance for these indexes. As expected for trust categories, average returns are lower than found with reinvestment of dividends but the relationship of average return and risk is the same with the greatest average rate of return and risk for the oil and gas area and lowest for business trusts. Note that on average all trust types had higher monthly rates of return than the TSX composite. We present this comparison, even though the TSX composite includes reinvestment of dividends, since dividends are not as important as in the trust area.

Table 10: Monthly Performance of Trusts, With and Without Reinvestment of 1996 to June 30, 2004 (%)

Composite Business Oil and

Gas REITs TSX

compositeDistributions reinvested Average 1.4 1.2 1.8 1.5 0.8 Standard deviation 3.7 3.6 5.7 4.2 5.0 Maximum 11 10.3 19.8 17.7 12.0 Minimum -17 -14.4 -20.5 -19.8 -20.1 Distributions not reinvested Average 0.97 0.87 1.13 1.17 n.a. Standard Deviation 2.8 2.8 4.0 3.5 n.a. Maximum 9.8 9.8 13.7 16.7 n.a. Minimum -13.8 -11.9 -15.2 -16.9 n.a. n.a. not applicable

We also measured degree of association of rates of return on various trust forms using the series without distribution reinvestment. We found that correlation between business trusts and REITs was highest at 0.76 and the relationship between REITs and Oil and Gas lowest at 0.52. Business trusts and Oil and Gas trusts had a correlation of 0.63. Results accord with expectations that business trusts and REITs have common influences. When considering Oil and Gas and other trust forms, the underlying influences on business trusts from energy related issues is higher than their impact on REITs. We also considered performance by looking at annual geometric rates of return over the period 1996 to 2003. In Table 11 rates of return are measured with distributions reinvested and in Table 12 distributions are not reinvested. When distributions are reinvested, the dividend is assumed to be used to purchase additional units at the prevailing price. Thus the number of units held in the index is actually increased. For normal corporate structures, distributions are not generally large and the reinvestment of distributions in stock is not a large investment. However, for trusts, distributions are large and the impact on performance can be substantial. For example, if distributions are reinvested and trust units increase in value, since there is now more invested in the stock, return will be greater than if distributions were not reinvested. The opposite effect is observed when unit prices fall. Rates of return with reinvested distributions are impressive. Of the 8 years in the sample period, there are two negative rates of return for business trusts and just one for each of the oil and gas and


REIT categories. Rates of return for the oil and gas index are very large, with the highest value for all trust forms at 56.8% in 1999. However they also had the largest negative return in 1998.

Table 11: Geometric Annual Returns (Reinvestment of Distributions)

Trust Composite Business Oil and Gas

REIT Index

1996 36.1% 36.6% 32.7% 46.0% 1997 8.9% 2.8% 5.4% 32.3% 1998 -13.4% -5.4% -33.1% -9.4% 1999 9.5% -7.0% 56.8% 10.5% 2000 29.2% 23.2% 50.9% 18.8% 2001 25.1% 31.4% 16.0% 30.2% 2002 14.0% 12.9% 19.5% 7.8% 2003 37.5% 32.8% 49.8% 27.0%

In Table 12 we calculate rates of return without reinvestment of distributions. This is equivalent to an individual investor taking distributions and spending them. While this may not be the best way to reflect the investor’s reinvestment policy, there is not an implicit investment strategy as in the distribution reinvestment policy. We also present annual rates of return on the TSX composite index. As expected, annual rates of return are affected in comparison with the situation with distributions reinvested, with largest rates of return being lower than under distribution reinvestment and negative rates of return being smaller. On average, there is a positive association with risk, as measured by the standard deviation. The oil and gas index has close to the highest average rate of return and the highest risk; the business trust index has both lower average rate of return and risk. We compared returns on the Trust composite to returns on the TSX composite. We observe that the average rate of return on the TSX was less and the standard deviation greater over the time period. In 2001 and 2002, even as returns on the TSX index were negative, those on the trust composite were positive.

Table 12: Geometric annual returns (no dividend reinvestment)

Trust Composite

Business Oil and Gas REIT TSX Composite

1996 34.3% 35.1% 30.8% 43.4% 28.3 1997 7.1% 2.2% 3.3% 29.1% 15.0 1998 -11.1% -4.6% -26.0% -8.1% -1.6 1999 7.1% -5.1% 36.6% 8.4% 32.0 2000 19.0% 15.1% 32.5% 12.9% 7.4 2001 15.7% 19.9% 10.4% 19.7% -12.6 2002 8.7% 8.5% 10.8% 5.2% -12.4 2003 21.2% 20.2% 24.6% 16.4% 26.7

Average 12.8% 11.4% 15.4% 15.9% 10.3 Standard Deviation 13.3% 13.9% 20.6% 15.6% 18.0


We also measure performance from a portfolio perspective using the annual Sharpe ratio. The Sharpe ratio is defined as the annual excess rate of return on a portfolio of securities divided by the standard deviation of rate of return. Hence the measure is a risk adjusted performance measure. Excess return is defined as the rate of return on the portfolio less the annual interest rate on a riskless bond. By comparing the Sharpe ratio for various portfolios against the same ratio on the TSX composite we can assess if the portfolio outperformed the market. In Table 13, annual Sharpe ratios for various trust portfolios and the TSX composite for years 1996 to June 2004 are presented.

Table 13: Annual Sharpe Ratio for Trusts and TSX Index

Year Trust

CompositeBusiness Trusts

Oil and Gas REIT TSX

1996 0.242 0.170 0.171 0.181 0.162 1997 0.046 0.007 0.009 0.168 0.062 1998 -0.093 -0.050 -0.116 -0.064 -0.016 1999 0.043 -0.083 0.211 0.050 0.112 2000 0.217 0.117 0.272 0.096 0.013 2001 0.117 0.231 0.028 0.158 -0.048 2002 0.109 0.114 0.089 0.042 -0.054 2003 0.434 0.398 0.301 0.269 0.142 2004 0.023 0.031 0.018 0.002 0.025

N 4 6 6 6 Looking at annual Sharpe ratios, in 2004 (until June) only business trusts outperformed the TSX index. For 2000 to 2003, all trust categories outperformed the TSX index. In 1999 only Oil and Gas trusts and in 1998 no trusts outperformed the TSX. This period was the high tech boom and it is no surprise that trusts in general did not do well. In the last row of the table, we identify the number of times the Sharpe ratio of the specific index outperformed the Sharpe ratio for the TSX Composite (N). Looking at the trust composite, it outperformed the TSX 4 out of 9 years. For all other trust indexes, there were six years in which there was superior performance although there were some differences in years in which the trusts outperformed the TSX index. Thus performance of trusts both individually and in the composite against a composite stock index was strong. Within the trust sector there was a trade off of risk, measured as standard deviation of return, and rate of return with higher risk trusts earning higher rates of return. The performance of trusts relative to the TSX composite was not strong during the 1998-1999 period. b. Distributions An important factor in an income trust’s performance is its distributions. The form of distribution has an impact on investors’ after tax cash flow from the trust. In addition, their size and priority generate some of the benefits for the trust. We now consider some elements of trust distributions.


Return of Capital Allocation of distribution to a return on capital and a return of capital is an important element for taxable investors. This issue is considered in Table 14 below where summary statistics are provided on the percent of distribution that was a return of capital for the years 1996 to 2003 for three trust types: business trusts, power and pipelines and oil and gas trusts. The data were provided by BMO Nesbitt Burns and reflect the trusts which they follow.29 Panel A considers business trusts. As can be observed in the entry for number of trusts, prior to 2002 the sample size is small, reflecting recent growth in business trusts. For all years (except 1998) the mean value exceeds the median suggesting that most observations are small in value but there are some large ones that pull up mean value. For 2002 and 2003 where we have the largest number of observations and new trusts, mean values are about 10% of distribution as a return of capital leaving a large taxable component. This small percentage is expected since business trusts generally are not ‘wasting’ assets and some reinvestment is needed in order to maintain value of assets. Return of capital amounts are higher in earlier years. One caveat is that average values include Atlas Cold Storage which has an anomalous high return of capital component, reaching 70% in 1999 and 2000. Panel B considers power and pipeline trusts which are capital intensive and likely to generate larger return of capital distributions. As expected the mean and median values are much larger than found for business trusts. Gaz Metropolitan is included in the average value but it has a zero return of capital percentage which is very different from other trusts in this category. Finally oil and gas trusts are presented in panel C. These trusts are based on ‘wasting assets’ and unlike business trusts there are no significant maintenance capital expenditures. This fact leads to a high return of capital percent in both mean and median, higher than found in power and pipeline trusts. Since oil and gas trusts have been in existence for some time we can observe a time series of return of capital distributions for seven trusts that have existed since 1996. Results are observed in panel D. In early periods, return of capital percentages were large and then fell as trusts matured. However, even in 2002 and 2003, amounts were greater than those observed for business trusts in the same years.

29 While the sample is reduced it is unlikely to cause any bias. Typically the investment dealers do not follow trusts with a limited market capitalization. Also in the pipeline and Oil and Gas area they follow most of the entities.


Table 14: Percentage of distribution that is Return of Capital, 1996 to 2003 Panel A: Business Trusts 2003 2002 2001 2000 1999 1998 1997 1996 Mean 10 11 22 26 28 23 32 Median 4 10 10 18 19 24 20 Number 20 16 5 5 5 4 4 1 *Atlas Cold Storage

35 28 69 70 70 37 75

Panel B: Power and Pipeline 2003 2002 2001 2000 1999 1998 1997 1996 Mean 52 57 60 67 68 72 75 Median 50 61 67 90 96 96 100 Number 13 11 9 9 9 5 4 1 *Gaz Metropolitan

0 0 0 0 0 0 0 0

Panel C: Oil and Gas 2003 2002 2001 2000 1999 1998 1997 1996 Mean 37 49 49 62 85 92 91 95 Median 36 42 35 51 82 95 100 100 Number 14 11 11 8 8 8 8 7 Panel D: Sub-set of seven oil and gas trusts 2003 2002 2001 2000 1999 1998 1997 1996 Mean 34 45 37 56 83 91 90 95 Median 36 42 35 51 82 95 100 100 *Source: BMO Nesbitt Burns

Distribution and cash flow As previously noted, one benefit from the trust structure is the large distribution relative to cash flow generated. This large distribution is a benefit to investors in two ways: it reduces management’s ability to undertake unprofitable investments and it generates cash distributions that meet investors’ needs. In Table 15 below, we present simple and weighted average values for the ratio of distribution to cash flow for business, power and oil and gas trusts for 2002 and 2003.


Table 15: Ratio of distribution to cash flow by trust type for 2002 and 2003

2002 2003 Business Simple average 0.82 1.00 Weighted average 0.79 1.21 Power and Pipeline Simple average 1.03 0.91 Weighted average 0.93 0.92 Oil and Gas Simple average 0.84 0.83 Weighted average 0.84 0.81 Source: BMO Nesbitt Burns

As observed in the Table, ratios are high for all trust types. In 2003, business trusts had an average payout of 100% or using a weighted average, 121%. The larger average value for the weighted average reflects high payouts of large capitalization trusts. During 2002, 4 out of 13 trusts had payouts of at least 100%. High payouts can be made either through borrowing or by using a reserve fund that may have been built up in previous years. Of course, payments over 100% can not continue for long time periods unless the company decides to issue third party debt and increase its leverage ratio. Oil and gas trusts had a stable payout of distributions over these two years.

Distribution growth With the importance of distributions to valuation of income trusts, we next consider their growth over the period 1997 to 2003. In Table 16 growth rates starting in various years and ending December 2003 are presented. The starting year includes trusts that had a full year of distributions; this requirement does not remove trusts that had eliminations of distributions. Given underlying characteristics of companies that fit the business and power and pipeline trust structure, it is unlikely that growth in distributions will be large. Revenue growth and operating margins will affect distribution and hence its growth. These trusts do not typically grow through acquisition. We consider business trusts first. Given growth in numbers in the past few years, there are not many trusts that have a long distribution history. Thus before 2002 there were no more than 5 trusts in the sample; for 2002 there are 13. As can be observed in Table 16, growth rates are small and negative except for the one year rate starting in 2002. With only two observations of companies that have been in existence since 1997, growth rates starting in the early years may not be representative. If we remove Atlas Cold Storage from the sample, growth rates starting in 1998 to 2000 are approximately 2%, from 2001, 0.9% and from 2002, 5.58%. Thus distribution growth as expected is not dramatically large over long time periods.


Table 16: Distribution annual geometric growth rates ending December 31, 2003 and

starting in the year noted (%) 1997 1998 1999 2000 2001 2002

Business Growth 6.44 -0.95 -1.07 -0.36 -1.22 4.36 Number 2 4 4 5 5 13 Power and Pipeline

Growth 0.50 1.82 1.83 2.25 2.11 2.43 Number 1 6 7 8 9 11 Oil and Gas

Growth 3.62 10.54 9.41 -2.57 -4.38 17.37 Number 7 7 7 7 10 10 Source: BMO Nesbitt Burns

Power and pipeline trusts have small, positive growth rates over all time periods. Growth rates are consistently about 2% and show little variability. Finally, the oil and gas area displays variable growth rates over the sample period ranging from 17.37% to -4.38%. These results are consistent with the underlying variability of commodity prices and some variability of distributions with changes in cash flows. c. Sensitivities to economic factors and abnormal returns Income trusts are equity based securities with unique characteristics, the most important of which is that the company distributes to unit holders a large proportion of its cash flow. Since underlying the trust is an operating entity, unit prices should be sensitive to general economic conditions affecting operations; these economic conditions are reflected in the rate of return on an overall stock market index. However, since distributions are such a large percent of cash flow, interest rate changes should also have an impact. This relationship is similar to a non-trust corporation such as a regulated utility which pays a large dividend. Hence trusts’ rates of return should be sensitive to both underlying macroeconomic factors. To assess sensitivity of rates of return on income trusts to macroeconomic factors, we relate the monthly excess rate of return on a trust index to the excess rate of return on a 5 year Government of Canada bond index and the excess rate of return on the TSX/S&P composite index over various time periods. The excess rate of return is defined as the difference between rates of return on a particular series minus the one month risk free rate of interest (Government of Canada treasury bill) at the beginning of the period. We begin the analysis using the TSX capped trust indexes for Oil and Gas trusts, REITs and all income trusts30. All return series reflect monthly total returns—cash distributions and capital gains or losses. Unfortunately the TSX/S&P capped trust index does not have a specific business trust sub-index. As of June 2004, there are 57 companies in the capped 30 The index caps the weight of any one trust in the relevant index at 25%. There are no trusts that reached this cap value. In order to be included on the index firms must meet minimum size and minimum length of time since listing constraints.


index representing 23 oil and gas trusts, 8 REITs, and 26 business trusts; the third group includes power trusts. The index is float value weighted, with oil and gas trusts having the greatest weight at 50%, followed by business trusts at 35% and REITs at 15%. With the heaviest weight given to oil and gas trusts, the overall index results will be affected by this sector’s performance and we may not be able to infer sensitivity and the performance of business trusts. Therefore we also use BMO Nesbitt Burns indexes which have a wider coverage and results presented by Halpern and Norli31 to assess business trust characteristics in subsequent analysis. To measure sensitivities to macroeconomic factors, we use two regression equations. The first, called model 1, takes the following form: Ri,t = at + bbond Ri,bond + bmkt Ri,mkt + ei,t Where Ri,t is excess return in month i on trust index t R i,bond is excess return in month i on a 5 year bond index32 R i,mkt is excess return on the TSX/S&P index ei,t is a random variable error term To interpret the results, the regression coefficients on the macroeconomic variables reflect the sensitivities of the trust returns to the bond and stock markets. The intercept, at , is an estimate of monthly abnormal rate of return of the portfolio of trusts, as represented by the index, after adjusting for macroeconomic influences. Thus a positive and statistically significant value implies that after adjusting for macroeconomic influences, the particular index had a positive abnormal performance.33 A positive coefficient on the bond index variable implies that interest rates affect bonds and trusts in the same direction. We also assess the impact of the time period from 2002 to June 2004, in model 2. This regression takes the following form: Ri,t = ai + bbond Ri,bond + bmkt Ri,mkt + bdummy D All variables are as defined above and D is a dummy variable taking a value of 1 for observations after December 31, 2001 and bdummy is the coefficient on the dummy variable. This approach does not allow sensitivities to interest rates and the overall market to change over the sample period. To interpret the dummy variable, intercept at is abnormal performance of companies in the particular index under consideration for the time period up to December 31, 2001. Coefficient bdummy reflects change in performance for years post 2001. If the coefficient is positive and significant, the post 2001 period had abnormal returns after adjusting for macroeconomic effects. The size of abnormal returns for post 2001 equals the value of the intercept plus the value of the coefficient on the dummy variable. Model 2 is intended to determine if there has been unusual performance of

31 “Income Trusts: Viable Financial Instrument or Product of the Economic Environment”, 2003 Capital Markets Institute conference on Income trusts. 32 We used the mid-cap Scotia McLeod Government bond total return index. 33 In fact, if we assume that the two macroeconomic variables are risk factors then the intercept in the regression can be interpreted as Jensen’s alpha which is a measure of the abnormal return after risk factors have been controlled.


trusts over the post 2001 period. We chose post-2001 because this period had lower interest rates, a recovery in the stock market and strong interest in income (especially business) trusts. As observed in model 1, over the sample time period, Oil and Gas, REIT and the overall income trust index all reflect positive sensitivity to the bond and stock market. Sensitivities are statistically significantly different from 0. All trust indexes have a high sensitivity to the bond market and a lower sensitivity to the equity market. The oil and gas trust index displays the largest sensitivity to bond and equity markets and REITs the lowest. None of the intercept terms are statistically significant, suggesting that over the whole period there was not any excess return earned by investors.

Table 17: Regression Results for TSX Income Trust Indexes 1998 to 2004(June)

TSX Income Trust Index

Oil and Gas Index TSX REIT Index

Model 1 Model 2 Model 1 Model 2 Model 1 Model 2 intercept 0.6294 0.4424 1.0257 0.9167 0.5677 0.6072 t statistic 1.5760 0.8808 1.6737 1.1868 1.4298 1.2130 b-bond 1.0209 1.0068 1.3400 1.3318 0.6766 0.6796 t statistic 3.4024 3.3532 2.9102 2.8846 2.2683 2.2718 b-mkt 0.3914 0.3908 0.5104 0.5101 0.3772 0.3773 t statistic 5.2431 5.2477 4.4557 4.4540 5.0830 5.0847 b-dummy 0.4946 0.2884 -0.1044 t statistic 0.6112 0.2318 -0.1295 R square 0.3325 0.3357 0.2653 0.2659 0.2834 0.2836 Bold values identify statistically significant coefficients

To consider model 2, we first observe that estimated sensitivities to bond and stock markets are unchanged. Second, coefficients on dummy variables are not statistically different from 0, suggesting that there was no abnormal performance in the post 2001 period. We next consider the BMO Nesbitt Burns Trust Index series for the overall income trust market and subsets reflecting business trusts (including power trusts), oil and gas trusts and REITs. This set of indexes has wider coverage of the various trust categories than the S&P/TSX index. Indexes cover the 1996 to June 2004 time period. With this data we use the same two regression models as found in the TSX index analysis. The results of these regressions are found in Table 18.


Table 18 : Regression Results for Models 1 and 2—1996 to June 2004

Trust Composite

Index

Business Trust Index Oil and Gas Index

REIT Index

Model 1

Model 2

Model 1 Model 2 Model 1 Model 2

Model 1

Model 2

Intercept 0.0033 0.0028 0.0027 0.0019 0.0042 0.0038 0.0043 0.0051 t stat 1.5883 1.1292 1.2479 0.7269 1.2425 0.9616 1.6518 1.6636

b-bond 0.7523 0.7511 0.8187 0.8168 0.7806 0.7797 0.8663 0.8680 t stat 5.1069 5.1020 5.2907 5.2875 3.2696 3.2660 4.6964 4.7109

b-mkt 0.2703 0.2707 0.2078 0.2085 0.3419 0.3422 0.3069 0.3063 t stat 6.6129 6.6269 4.8389 4.8631 5.1622 5.1657 5.9976 5.9895

b-dummy 0.0018 0.0029 0.0012 -0.0028t stat 0.4101 0.6262 0.1721 -0.4940

R square 0.4364 0.4373 0.3638 0.3662 0.2914 0.2916 0.3916 0.3931 *bold entry signifies statistical significance at the 1 % level Let us start with model 1. We observe that for all trust sub indexes and the composite, rates of return for all trust types are sensitive to both the bond market and stock market. Given that a sensitivity coefficient of unity reflects average sensitivity of a company to the market index, all income trust forms have market sensitivities much less than unity reflecting lower than average operational and leverage induced risk. As observed in Table 17,, the coefficient on the bond index variable is much higher than the coefficient on the market index. Under reasonable assumptions, this suggests that these trusts are more sensitive to interest rates than to the overall market. Further, all intercepts are not significantly different from zero, implying that over the whole time period there is no evidence that investors had over (under) paid for trusts and subsequently earned below (above) normal returns. We next consider model 2 which adds a dummy variable reflecting time periods after 2001. For all trust types and the composite, coefficients on the dummy variable and the intercept are not statistically significant from zero. This result is consistent with that observed in model 1 and implies that the sub-period following 2001 did not provide excess returns to income trust investors. However, both the S&P/TSX and the BMO Nesbitt Burns indexes are value weighted and the results we obtain may reflect impact of large trusts and may not be relevant for small ones. To address this issue we rely on study results by Halpern and Norli in which they constructed their own indexes based on portfolios of large and small trusts over the period 1996 to 2002. They also introduced a dummy variable for the time period subsequent to 1999 to reflect poor performance of the equity market.


Considering the overall time period with no adjustment for the period after 1999, we find that in the Halpern and Norli equivalent of our model 1, intercepts for all trust types and the overall trust portfolio which includes all trusts were not statistically different from zero. When the dummy variable for periods beyond 1999 was introduced (model 2), it was positive and statistically significant for business, oil and gas trusts and the overall trust sample. Thus during this sub-period, investors in these trusts earned abnormal returns. The amount of abnormal return over this time period for business trusts was 1.1% per month. Even more interesting was the difference between large and small trusts defined as trusts that are larger and smaller than the median market capitalization for the respective income trust category. For model 1, large trusts had insignificant intercepts regardless of trust type. When the dummy variable is introduced, it is significant for business trusts and the overall sample of large trusts. Thus any over performance for the overall large trust sample was generated by the business trust sector, although it was not large. The picture is different for small trusts. For all trusts except oil and gas, the intercept is positive and statistically significantly different from zero. When the dummy variable is introduced, all trust types except REITs are statistically different from zero. This result suggests that outperformance of trust types was due to the 2000 to 2002 period. For REITs strong performance in 2000 to 2002 was not sufficient to generate outperformance over the whole period as observed in model 1. The study’s conclusion is that, ‘there is no convincing evidence that income trusts as an asset class have experienced abnormal performance over the period 1996-2002. There seems to have been slightly different performance for the small versus large trust categories and this difference was primarily due to the performance during the 2000-2002 period.’ Based on our analysis of more recent data from January 1996 data to June 2004, we concur that there is no evidence that income trusts, in any form, experienced any outperformance. While there may have been subperiods where outperformance occurred, over the whole time period, this was not the case. Thus on average, the market priced these securities properly given their risk as measured by sensitivity to the stock and bond markets.

4.3.2 Follow-on financing

The purpose of income trusts is to distribute a large portion of cash flows to unitholders. Trusts thus need to return to the capital market to obtain funds for corporate purposes. Follow-on or secondary financings can be used to generate growth either by acquisition or by expansion of firm operations through opening new businesses or entering new markets. Alternatively, funds can be used to buy out some or all of the holdings of the firm’s founders or venture capital providers, including institutions.34 These parties want to monetize their investment and move on to other opportunities, whether investment related for institutions and venture capitalists or consumption/new investment for founding shareholders. Follow-on financing was a significant part of total capital market financing activity since 2000 when equity issues for high growth companies dried up.

34 Yellow Pages (YPG) is an example of follow-on financing intended to purchase the units of venture capital providers. In 2003 YPG issued $1.5 billion and in 2004, $0.7 billion for this purpose.


Table 19 below presents the percentage of follow-on trust financings, both in number and dollar value of deals, that were used exclusively either to buy out some existing unitholders or for the corporate treasury. This data was provided by CIBC World Markets and reflects information on trusts which they follow.

Table 19 : Percentage of Follow-on Financings by Stated Purpose by Trust Type Trust Type Percent of Deals Exclusively

Purchase of Existing OwnershipPercent of Deals Exclusively

Treasury Number of

Deals Value of Deals Number of

Deals Value of Deals

Business 26% 64% 67% 31% Excluding YPG 22 41 71 51 Power 13 20 88 80 Oil and Gas 2 4 97 95 REIT 2 3 96 95

For example, for business trusts, 26 percent of deals, by number were used to purchase outstanding units from venture capital providers or original management while 67% were used for treasury purposes. We look at dollar value of deals, where percentages are 64% and 31% respectively. As noted previously, Yellow Pages had two very large transactions and when removed from the sample, percent of dollar value of deals used to reduce venture capital ownership falls to 41%. For Oil and Gas trusts and REITs about 95% of the follow-on offerings, in terms of value, were for corporate treasuries. In the power trust sector, 80% of follow-on financings by dollar value were used for corporate treasury purposes. The relative importance of follow-on financing to purchase units of existing investors in the business trust structure compared to other trust types reflects the difference in maturity of various trust types. The bulk of business trusts was established after 2001 whereas other trust types began much earlier. Thus for the latter any ownership interests of founders or venture capital providers were removed much earlier. Further, business trusts by and large are established in companies that do not anticipate large growth whereas Oil and Gas trusts and REITs use new funds to acquire new properties or other companies. The dollar value of funds raised in follow-on financings over the period 1995 to June 2004 was substantial. Table 20 below presents information on funds raised by trust type.


Table 20: Follow-on Financing 1995 to June 2004 by Trust Type

Business Trusts

Business Trusts (excluding Yellow Pages)

Power Trusts

Oil and Gas Trusts

REITs Total Total (excluding Yellow Pages)

Market Cap ($billion)

$5.8 $3.5 $3.1 $10.9 $5.7 $25.4 $23.1

No. of deals

46 44 32 142 88 308 306

Average size ($ million)

$125.6 $80.3 $95.7 $76.6 $64.2 $82.4 $75.5

When we consider all trust types, excluding Yellow Pages, there was $23.1 billion raised with Oil and Gas leading at $10.9 billion. In terms of number of issues, Oil and Gas again was largest at 142 deals with REITs following at 88 deals. Power trusts had the largest average deal size followed by business trusts and Oil and Gas trusts. Although there are a large number of issues over the period, there are many instances of companies that were multiple issuers.35 Given the importance of acquisition in the Oil and Gas and REIT area, it is expected that there would be more multiple deals for these trust types as a proportion of total issues than for business trusts. In Table 21 we present information on single and multiple issuers by trust type. To assist in interpreting the table, consider the entry for Total, all Trust types. There were 57 issuers who had multiple issues and these issuers had 268 issues. Obviously the number of issuers and number of issues are the same for single issue entry. Finally 58% of all issuers were multiple issuers and 87% of all issues were multiple issues. Considering specific trust types, all but business trusts had multiple issues as a percent of all issues at 94%--business trusts at 46% was much smaller. Business trusts had the largest number of single issuers.

35 Some of the larger multiple issuers by trust type are as follows: Business Trusts: Yellow Pages, Superior Plus; Power Trusts: Inter Pipeline Fund, Algonquin Power; Oil and Gas: Pengrowth, Canadian Oil Sands; REITs: Rio Can, H&R


Table 21: Frequency of Issuers and Number of Issues by Trust Type and Total Trusts

Business

Trusts Power Trusts Oil and Gas

Trusts REITs Total, all trust

types # of

issuers # of

issues # of

issuers # of

issues# of

issuers# of

issues# of

issuers# of

issues # of

issuers# of

issuesMultiple 7 21 9 30 23 134 18 83 57 268 Single 25 25 2 2 9 9 5 5 41 41 Total 32 46 11 32 32 142 23 88 98 309 Multiple as % of total

22 46 82 94 72 94 78 94 58 87

Given the size and importance of this follow-on market, how well does it function? Clearly with the large number of multiple issues, investors have continued confidence in the market. Another way to evaluate the functioning of the market is to consider the price at which follow-on financing is undertaken relative to the last trade price of the security. The closer issue price is to last traded price, the better is the market functioning. There is no reason to expect the price will be identical to the last traded price but large discounts suggest that the market is not working well since new investors are receiving a unit at a lower price than the current unit market price and this is at the expense of existing investors. We estimate a discount to the last trade value as (last trade price-issue price)/last trade price)*100. For example, if the last trade price is $10 and issue price is $9.80, the discount is 2%. Over the period 1995 to 2004 the discount for all trusts was 3.2%. Discounts ranged from a high of 3.9% for Oil and Gas Trusts to a low of 2% for Power Trusts. These values reflect, to some degree, differences in risk for trust types.

Table 22: Discount to Last Trade Value by Trust Type Business

Trust Power Trust Oil and Gas

Trust REIT All Trusts

Average Discount

2.8% 2.0% 3.9% 2.7% 3.2%

Standard Deviation

3.3% 3.7% 2.3% 2.1% 2.6%

Discounts also differ over time. Below we provide average discount for all trust types for all years from 1995 to 2004.

Table 23: Average Discount for all Trust Types by Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004Average discount (%)

4.1% 1.9% 1.5% 3.4% 3.5% 3.7% 3.9% 3.1% 3.4% 2.4%


In early periods follow-on financings were exclusively Oil and Gas and REITs. Power trust became issuers starting in 1998 and business trusts, apart from a flurry in 1997, became more important starting in 2002. Since the majority of deals are bought deals, the discount noted above falls at the lower end of the 2 to 6% range of discount for bought deals of non-trust issues. Other Financing for trusts Companies have also issued new third party debt in the form of convertible debentures, issued either alone or at the same time as new units.36 The use of convertible debt is relatively new. Table 24 below presents information on convertible debt issues from 2000 to the end of August 2004. There were no issues for the period 1995 to 1999.

Table 24 : Statistics on new convertible issues by income trusts 2000-2004, $millions 2004 2003 2002 2001 2000 Number 16 8 10 2 1 Market Capitalization

$1,060 $715 $856 $148 $35

Average Size $66 $89 $86 $74 $35 Source: Investment Dealers Association

Over this time period the greatest number of issues was in the Oil and Gas trust area with 14 and REITs with 13. Business and power trusts made less use of this security. Over the period of 2003 to 2004 oil and gas trusts issued 11 convertible debentures and REITs 9. As at the end of August, 2004 there were 28 convertible securities outstanding for which there were 19 unique issuers. A convertible debt security is a financial instrument that can be thought of as a combination of a straight debt instrument, which provides a floor to the value of the instrument, and an (call) option to purchase new income trust units. Since the option has value, the interest rate charged on the instrument is less than the rate that would have been paid if straight debt were issued. In fact, the greater the volatility of the underlying unit price, the more valuable is the option and the lower the interest rate that is paid. With the straight debt floor component, this instrument can be considered as a less risky instrument and will appeal to those investors who want to lower risk by having debt yet have the benefit of an increase in unit value. To appreciate lower risk properties of convertible debt consider the situation of an oil and gas trust when there is an increase in variability of underlying commodity prices. With added risk, straight debt value will be less since there is a higher probability that cash flows could fall. However, offsetting this is the increase in value of the security’s option part. The combination reduces overall risk of the instrument and variability in its value. Thus it is no surprise that the largest number of issuers of convertibles over the 2003 and 2004 period were REITs and Oil and Gas trusts.

36 For example, Harvest Energy Trust issued $100 million in subscription receipts and$ $175 million in convertible debentures in the third quarter of 2004.


5.0 Implications Income trusts are equity securities that have exposure to both overall market and interest rate movements. There remain a number of controversial elements regarding income trusts. We discuss two of these: income trusts in the Index and the recent Budget proposals to cap pension fund investments in business trusts

5.1 Income Trusts in the Index One topic in the income trust area that generates heated discussion is the possible inclusion of income trusts in the TSX index. Concern is generally voiced by institutional investors who, following index strategies, would be forced to hold income trusts and for specific reasons, they do not want to hold any income trusts. Of course, the surprising element here is that many institutional investors have exposure to income trusts through holdings of REITs and Oil and Gas Trusts since the trust structure is dominant in these industries. To put the income trust market in perspective, in aggregate the income trust market has a market value of about $100 billion compared to market value of the TSX of $1.238 trillion. Table 25 below presents the top and bottom twelve trusts ranked by quoted market value—number of shares adjusted for control holdings times price per share as at the end of June. We also identify turnover for these trusts, defined as volume of transactions as a percentage of number of shares outstanding adjusted for control blocks for the month of June. Of the top twelve trusts, 6 are energy trusts, 2 are REITs and 4 are business trusts. This is about the same proportions as the overall S&P/TSX income trust index. For the smallest twelve, all but two are business trusts. While some of the income trusts are large, only a few of them would enter the TSX/S&P 60 Index. In fact, the largest trust has a quoted market value equal to that of Domtar or Molson. These stocks are ranked 44th and 45th in the TSX/S&P 60. Thus introduction of the largest trusts to the TSX 60 would not likely include many trusts. However, inclusion of trusts in the S&P/TSX Composite would likely have a more profound impact. A rough estimate is that about 50 names could be added to the composite and this could be an increase in market capitalization. Further with the introduction of trusts with high distributions relative to the distributions of companies currently on the composite, there will be an upward impact on the dividend yield, potentially up to 50%. However, the current dividend yield on the Composite is not high.


Table 25: Market value and turnover of top and bottom twelve trusts in the S&P/TSX

Income trust index Stock Name Quoted

Market Value

Turnover

Largest $000,000 (%) ENERPLUS RESOURCES FUND TRUST UNITS 3,920.5 7.42 YELLOW PAGES INCOME FUND UNITS 3,892.1 3.50 CANADIAN OIL SANDS TRUST UNITS 3,863.2 9.53 RIOCAN REAL ESTATE INVESTMENT TRUST UNITS 2,896.6 3.85 ARC ENERGY TRUST UNITS 2,777.5 3.66 PENGROWTH ENERGY TRUST UNITS 2,526.6 3.23 FORDING CANADIAN COAL TRUST UNITS 2,031.7 3.19 SUPERIOR PLUS INCOME FUND TRUST UNITS 1,845.5 3.72 PETROFUND ENERGY TRUST UNITS 1,472.2 4.60 H & R REAL ESTATE INVESTMENT TRUST UNITS 1,443.5 2.93 ENERGY SAVINGS INCOME FUND UNITS 1,438.9 3.71 PEYTO ENERGY TRUST UNITS 1,372.2 3.59

Smallest

LEGACY HOTELS REAL ESTATE INVEST. TRUST UNITS 474.6 5.55 BORALEX POWER INCOME FUND TRUST UNITS 448.0 3.98 NORANDA INCOME FUND CL 'A' PRIORITY UNITS 423.8 2.71 CHEMTRADE LOGISTICS INCOME FUND UNITS 423.4 3.14 BELL NORDIQ INCOME FUND UNITS 415.7 2.83 GREAT LAKES HYDRO INCOME FUND TRUST UNITS 390.8 5.37 ROGERS SUGAR INCOME FUND TRUST UNITS 357.8 2.98 CLEARWATER SEAFOODS INCOME FUND UNITS 342.6 2.63 CLEAN POWER INCOME FUND TRUST UNITS 320.6 3.55 ATLAS COLD STORAGE INCOME TRUST UNITS 267.9 8.79 KCP INCOME FUND UNITS 233.2 4.65 HEATING OIL PARTNERS INCOME FUND UNITS 199.7 5.99

To frame this debate, we first address the purpose of any security index. The obvious rationale is that it reflects the investible universe of securities of a particular type. Further the index can serve as a naïve investment strategy and by implication it can operate as a benchmark to assess performance of managed portfolios. In the income trust situation, while there is a separate income trust index37, income trusts are not included in any equity index that reflects the overall stock market. Those who want to keep the income trusts out of the overall equity index make the following arguments: income trusts are not truly equity; income trusts do not have limited liability; and income trusts have different governance than regular equity securities. We consider each in turn. 37 The S&P/TSX Income trust index is a value weighted index of REIT, Oil and Gas and Business firms that meet certain size and age criteria. There is a total trust index, and separate REIT and Oil and Gas indexes.


First, income trusts are equity securities. An important element for an equity security is that equity holders are residual claimants, receiving payments only after all other claimants receive theirs. In the income trust, unit holders, while they receive interest and dividends and return of capital, these payments are subordinated to third party debt. Hence unitholders are residual claimants. Just as non-trust structures, they range in market capitalization but with a size constraint found for inclusion in the index, they are no different from other equity securities. Further, rates of return are sensitive to macroeconomic variables such as interest rates and the overall stock market. While sensitivities to these factors may differ from sensitivities displayed by non-trust companies, differences do not suggest that they are not equity securities. Another argument is that trust securities are not equity since there is no growth—they are designed to distribute a substantial portion of cash flow and thus must grow through issuance of units or other securities. These factors do not imply that trusts are not equities; only that they have different distribution policies and growth strategies than many other equity securities. Note that there are also companies in the index that have high, but not as high as trusts, distribution ratios. The second argument is that income trusts do not have limited liability. While this is arguable in the business trust case, the problem, if it exists, is being resolved by legislation. Alberta has passed legislation that introduces limited liability and the Ontario government has tabled legislation to the same end. Quebec has always had limited liability for trusts. Third, differences in governance are sufficiently different to keep trusts out of the index. As argued previously, Corporation law combined with securities regulation and listing standards for exchange traded trusts has made governance similar for trusts and non-trust companies. While some differences will continue, if they are significant they will be priced in the trusts. In conclusion, there is no strong reason to exclude trusts from a general stock market index. They compose an important part of the capital market and they are equity securities. If pension funds continue to feel they are not acceptable as investments even though they have an indexing strategy, they can exclude them from the index they hold.

5.2 Federal Budget proposal on pension fund holdings of business trusts: The impact on the Business Trust market

On March 23, 2004, the federal government introduced budget provisions that placed a limit on pension fund investments in Business Trusts of 1% of total assets. In addition, a pension fund could not hold in excess of 5% of assets of any one trust. These provisions were applicable only to business trust holdings and not REITs or energy trusts. They applied only to pension funds but not to Registered Savings Plans or on agents of the Crown such as the Caisse de Depot in Quebec. On May 18, 2004 these budget provisions were suspended pending discussions with affected parties. The rationale for introducing these provisions is not difficult to discern. As noted in Section 3.2.1 above, the trust structure generates current tax losses (tax leakage) to the government as investors in trusts receive distributions in a tax efficient manner.38 Government, while recognizing the tax 38 There were two studies of the tax leakage due to the trust structure. The first prepared for the Capital Markets Institute by L. Aggarawal and J. Mintz identified assessed the size of the tax leakage. A second study prepared by HLB Decision Economics Inc. was commissioned by the Canadian Association of Income Funds and Canadian Institute of Public and Private Real Estate Companies. This study used a different methodology and identified a smaller tax leakage.


leakage was currently small, believed there was a significant threat that pension funds investments in business trusts would increase dramatically as a result of introduction of limited liability for business trusts in the Province of Ontario. Currently, new issues of business trusts, apart from a few blockbuster issues, are not very large. However, there are large publicly traded companies whose operating characteristics are conducive to a business trust structure. With pension fund money available, tax leakage could become large if these firms converted to a business trust structure.39 Since pension funds do not pay taxes on business trust distributions, Government was concerned that tax leakage would be significant in the future. The pension fund response to this action was predictable and measured. They addressed discriminatory aspects of the budget provisions and made two additional important points. First, these provisions would remove them from large infrastructure venture capital projects since they could end up with an investment in excess of the cap. Second, the tax leakage argument for business trusts was addressed directly by another research study which demonstrated that losses were small. The important insight in this study is that while taxes paid by pension funds and RSP investors may be low in current periods, taxes will be collected in future as funds are paid out to beneficiaries. It is the present value of these taxes which should be of interest. Note, it is possible that including future taxes that will be paid by investors, there may be no loss or a small tax loss to government from a present value perspective.40 Further, when a firm becomes a trust, either through a conversion or an IPO, original shareholders have an increase in value that reflects gains from the trust structure. This increase in value is ultimately taxable as well. This is a further tax flow to government. Reducing pension fund exposure to the business trust market has serious implications for the economy and for the trust market’s efficiency. To the extent that the there is a reduction in business trust activity in general there will be a reduction of non-tax benefits of business trust structures such as removal of agency costs and improved monitoring when trusts need to return to capital markets to raise funds for growth. Further, the trust structure is a form of exit strategy for certain types of private equity. While high growth venture type companies cannot exit through the trust structure, there are a number of large projects, private companies wishing to go public, and divisions of existing companies that will be assisted by the presence of the business trust structure. In order for capital markets to work well and provide good price signals, outstanding securities should be traded in liquid markets. New issues of securities should be evaluated by sophisticated investors who can ultimately decide on value and in some situations whether issues should even be undertaken. Ensuring pension fund investors, who are generally sophisticated investors, are included in the institutional investor mix with mutual funds, will provide and improve this added discipline and bring liquidity to the trust market.41 By limiting pension fund exposure to business trusts, the depth and quality of the business trust market will be inhibited and will not improve. The net effect

39 Manitoba Telephone is an example of a large company that expressed interest in converting to a business trust. Its share price increased upon the announcement that the company was investigating the conversion. 40 To address the future tax leakage argument for introducing caps, the Pension Investment Association of Canada commissioned another study by HLB, “Tax Revenue Impacts of Pension Fund Investment in Business Trusts:. This study concluded that the potential tax leakages was not large. 41 There is a growing academic literature on the importance of reputational intermediaries to investor protection and hence valuation. Coffee identifies these reputational intermediaries as underwriters, auditors, equity analysts, and institutional investors. See John. Coffee, (2002), “Racing towards the top? The Impact of Cross-Listings and Stock Market Competition on International Corporate Governance”, Columbia University Centre for Law and Economics Studies Working Paper #205 (May)


of the budget provision would be to limit the growth of a vibrant part of the capital market and would result in less liquid and efficient capital markets.

is the trust in trusts misplaced?resulting trust is riskier than the average, but this is no...

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