Stability trumps size of trust payouts

(April 7, 2005) Despite their relatively short history on the investment landscape, the term “income trust” is already becoming a little dated. Due to differences between Canadian and U.S. tax law, new structures have been created to accommodate cross-border investment vehicles that accomplish the same goal — tax-efficient distribution of earnings.

The future will likely see more U.S.-based assets structured as either Income Participating Securities (IPS), Income Deposit Securities (IDS) or High Div C Corporations, which, as their name suggests, are structured more like a standard corporation, but pay out a much higher dividend than traditional equities.

Whatever their structural differences, demand for income vehicles remains strong, despite increasing voices of caution.

Some believe that trusts have become overvalued, carrying a premium valuation over their common equity counterparts. In a panel discussion hosted by the Strategy Institute, Sandy McIntyre, vice-president and senior portfolio manager for Sentry Select, said this is only partly true.

For some sectors of the trust universe, he says there is no premium assigned over the common equity equivalent, pointing to valuation on both structures in the oil and gas sector as an example. In many business trusts, though, he agrees there can be a premium assigned.

“It’s the mathematics that makes it warranted,” says McIntyre. “You take the equity model, you have long-term earnings growth plus a dividend, and if you are successful with your investment over a 10-year time horizon, 80% of your return is on the closing transaction. With the trust model, I get my return front-end loaded. The closing transaction is much less important.”

There has been increased focus in the media on the emergence of more cyclical businesses entering the income securities field, raising questions of hedging their exposure. McIntyre says he prefers to see these factors mitigated by a conservative payout ratio which will allow the structure to maintain its distribution through the hard time.

Some income trusts have been paying in excess of 100% of their earnings as distributions, which can clearly lead to problems down the road should business falter. McIntyre suggests investors will appreciate the stability offered by a payout ratio of 75% to 85%. But the fund must be careful to pay out enough of its earnings to avoid taxation.

There are some exceptions, though, says Kevin Charlebois, president, CIO and director of SoundVest Capital Management. Higher growth oriented companies can sometimes afford to pay out a higher percentage of their earnings based on the presumption of higher earnings in the future. But he would still prefer to see three to six months worth of distributions saved up in reserve, just in case.

Analyst coverage can make the security more liquid and therefore easier to get out of, but for professional investors, it can make the initial purchase price a little too high, since it’s more well-known. McIntyre says the market tends to overpay for liquidity, overlooking the quality of the underlying business.

Regulatory concerns

There is also some regulatory concern over new offerings in the income securities field. Because of their structure, the trust itself files the prospectus on which potential investors base their decision to invest or not invest.

But the owners of the underlying operation are not liable for this prospectus, even though they are the beneficiaries of the offering, says Ilana Singer, legal counsel, corporate finance, at the OSC.

The money raised by the trust’s IPO flows to these owners as they sell their business to the trust. These companies are often privately held prior to the offering, exempting them from regulatory filing requirements.

As such, these are seen by regulators as indirect offerings, which Singer says the Canadian Securities Authorities would like to see governed by the same rules as direct offerings.

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