Institutional investors already in trust market

He says that the much-talked-about theoretical unlimited liability issue has been used as the excuse for missing the boat by many managers. The resolution of the issue will remove this hindrance and allow managers to buy into trusts while saving face.

“I believe that this limited liability legislation is very significant,” Gluskin said.

But while some funds have avoided the potential liability issue by avoiding trusts, Teachers’ has set up a subsidiary, called Golden Apple, to insulate the main fund from potential lawsuits before the liability legislation is passed. This has allowed the pension plan to play the trust market in a relatively safe manner.

“The concern when you’re a large pool of assets is that in natural disasters, no matter how slight it is, the lawyers are going to ‘Oh there’s deep pockets there’ and there’s more incentive to launch a lawsuit,” says Morgan McCague, senior vice-president of quantitative investments for Teachers’.

McCague agrees with Gluskin that the legislation will be an important step, in that it will remove a theoretical stumbling block and likely lead to the inclusion of trusts into the major indices.

“The biggest hurdle for income trusts going into the index will be removed,” he says. “Once that’s gone, I think there will be a lot more attention paid to this area.”

But after the liability issue is cleared up, there is no guarantee managers will load up on trusts.

“It’s already harder to find good value in the trust space, after 25% compound annual return over the past three years,” said Sandy McIntyre, vice-president and senior portfolio manager for Sentry Select Capital Corp. “The reality is, this is the new small cap market. Most of the pension plans will typically look to the index-eligible names for their first cut.”

Gluskin says larger trusts, such as Yellow Pages, are more “perfectly priced” because they have been scrutinized to such an extent that everyone in the market has roughly the same information.

Smaller trusts, however, tend to slip under the radar. Often they are reluctant to pay for a stability rating analysis, which can potentially leave them undervalued.

“There are a handful of really spectacular growth trusts,” said Gluskin. “You see a smaller trust that appears to be undervalued and you scratch your head and wonder why. If the case is that it’s so illiquid, not that many people research it, not that many own it, then what happens is that if they grow, you’ll have the double whammy.”

He calls the widespread growth of 2003 a fluke, but that investors can expects gains of 9% or 10% for 2004 on certain trusts.

So if institutional investors are already selectively buying into the trust market, a better question might be ‘what are they looking for?’

“I’m looking for proper capital structure and true definition of sustainable free cash flow, those are my key decision points,” McIntyre said. “If I happen to get a nice clean board with it, that’s wonderful, but the reality is there aren’t very many clean boards in Canada.”

One of the major shifts in the trust market in recent years has been in the structure of governance, with externally managed trusts moving to internalizing management. This was an important step, McCague says.

“We definitely prefer internal management — it is an issue,” says McCague. “We feel their interests are far more aligned with our interests. Some of the external management performance structures had management picking up fees for acquisitions — things they should be doing — it’s a rip-off.”

As the market matures, McIntyre says there have also been negative developments, such as the creation of separately tradable subordinated debt, which threatens the co-operative approach of trusts.

“The great attraction to the income trust structure is subordinated debt is at common purpose with equity. In the event of a failure in the top-line cash flow, subordinated debt does not petition the company into bankruptcy,” said McIntyre. “You cut your distributions, you go through the trough and come out whole. We haven’t had a bankruptcy in the trust sector.”

He says the issuance of convertible debt on a diminishing resource, such as the oil and gas trusts is an instant “sell order” and that it is a smarter investment to hold the debt.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com