2010-08-19 Interview With Bay Street Fund Manager
Regarding Income Trusts
FM: The issue has always been one of, I think, a
misunderstanding by politicians of the impact of capital structure on cash flow
streams and how they’re impacted by taxation.
In the original structuring of income trusts in the mid 90’s, it was
very clear to us on Bay Street that what we were doing was replicating a common
private equity or leveraged buyout structure and packaging it in a form that made it accessible to middle
class investors.
The generation one income trusts were structured with a
layer of senior debt that would be typically bank debt. That would be somewhere around 20 to 25% of
the capitalization. The remaining
capitalization was split between subordinated debt and equity in lines with
common thin capitalization structures.
It’s generally, under the senior debt you are allowed to use two thirds
subordinated debt and one third equity.
That would result in a capital structure that would end up being about
15 to 17% equity. As a retail investor,
or as a private equity investor, you’re indifferent about the volatility of the
equity because your principle investment is the subordinated debt which is removing
cash flow from the business pre-tax.
If you went and you looked at the BCE circular that was
distributed in the summer of ’08 what you’ll find is that Ontario Teachers and
their US hedge fund partners, private equity partners, were using exactly this
type of structuring to remove the pre-tax cash flow from BCE.
Now when the department of finance started to get
exorcised about the income trusts what they saw was two publicly listed
entities one of which used superior tax planning to flow through the pre-tax
income to the beneficial owner of the units, and the other which retained the
pre-tax income to provide, in quotation marks, “growth.”
It was in the view of the department of finance that
having two publicly listed capital structures was inappropriate. In a meeting I had along with *** in
September of ’05, after Mr. Goodale’s initial announcement and before his about
face, Mark Carney very clearly told us that there was no way that they would
normalize corporate taxation down to eliminate double taxation of dividends for
taxable investors, in effect lowering the combined corporate and personal tax
rates. They were going to insist on
increasing the combined personal and corporate tax rate of the income trust
cash flows.
As he eloquently put it he “writes the budget and they’re
going to spend every penny of the money.”
He is an arrogant little prick.
Now he’s ex-Goldman and he doesn’t understand retail
investors and I think he in his comments demonstrated to me a contempt for the
retail investor. My client’s are retail
investors, they’re Canadians, and he was demonstrating contempt for my clients
and I don’t like that.
Now in the legislation that was subsequently put together
by the department of finance under the guidance of Mark Carney, they only
eliminated publicly traded income trusts, they call them SIFTs: Specified Investment Flow-Throughs. A private SIFT is absolutely fine and is
allowed to continue to exist. Now
examples of private SIFTs are: legal
partnerships, accounting partnerships and private companies that are controlled
using a flow-through structure. Now as
the income trusts evolved in the mid double 0s, it was determined that the
original structuring which was a trust on top of a corporation and a
corporation capital structure being the subordinated debt and equity was
inefficient. Really all you needed to do
was put the ownership of the business into a trust completely and flow 100% of
the taxable income out of the trust to the top trust and distribute it to the
unit holders.
After Mr. Flaherty’s announcement in October of 06 we had
a representative of OMERs, the Ontario Municipal Employees Retirement Plan visit
us to discuss the trusts in general which would be suitable for them to look at
as potential acquisition candidates subsequent to the downturn in the
market. One of the comments that this
representative made to me was that the second generation income trusts were
ideally structured for them to own directly all the legal work was done. They just needed to buy them and put them
away. So if you’re a golfer every time
you go to Golf Town remember that you are providing pre-tax cash flow to fund
the retirement benefits of the OMERs retirees.
Now as a Canadian citizen, I find this irritating. I don’t see why a retired civil servant
should be allowed access to a capital structure that enables them to access
pre-tax cash flow and my mother is not allowed access to that same capital
structure.
The legislation was written by the Department of Finance
who are members of the PSP, the Public Service Pension Plan, and indeed the
Public Service Pension Plan has been an active buyer of non-compliant income
trusts. They bought Retirement
Residences REIT, the legislation would not permit it to continue as a true REIT
and they bought Thunder Energy Trust.
Now I am not saying they bought the best assets, but they participated
in this.
The Capital Structure that you can use in private direct
ownership is generally much more aggressive than you would have in a public
market circumstance. Generally public
markets get antsy when debt levels get over a certain point. We focus on interest coverage, we focus on
balance sheet ratios. We are trying to
manage risk in our asset base. As a
private investor where I don’t have to mark to market on a daily basis and I can
control business directly over a period of years, I am indifferent as to
whether it is equity in the business or debt in the business. I want to ensure
that there is adequate capital in the business. I don’t want to over capitalize
it, that’s lazy capital. I don’t want to under capitalize it, because the
assets will deteriorate over time. A private owner of a business will typically
make a shareholder loan to the business in order to inject additional capital
and they want the flexibility of being able to inject or take capital out without
dealing with the equity account and having to do dividends, capital dividends,
it’s complicated.
The flexibility of a Private Structure, particularly when
you are a foreign company looking at Canadian assets and knowing you have an
ability to flow income from a medium tax jurisdiction in Canada and the low tax
jurisdictions in the Caribbean or the Channel Islands and accumulate that
capital without paying tax in your own country is a very interesting
proposition. It’s like the Irving Family, but it would be like X-Trada buying
Falconbridge, it would be like CVRD buying Inco. And what we have in Canada
appears to be a government that is unwilling to impose effective thin
capitalization rules, is very open to private equity ownership of businesses,
doesn’t look at corporate taxation in the public structure versus corporate taxation
in private structures. They’re trying to attract the capital investment, and
they’re indifferent as to where it occurs. The result is that we’ve had a
migration of businesses out of public markets into either foreign direct
ownership, private or foreign public direct ownership, and domestic private
direct ownership. The actual data is
pretty astonishing and I have been unable to get the press to write about this.
I have no idea why not. Now I stopped updating my data in mid 2008, but between
January 2002 and mid 2008 there were 155 announced and completed M&A
situations in Canada with a value of $297 billion these are TSX listed
companies, trusts, corporations that were targeted for M&A activity. Of
that total, 52.9% were bought by foreign public companies. This is CVRD buying
Inco, this is Xtrata buying Falconbridge, it’s US Steel buying Stelco, Dofasco
being taken out by Arcelor Mittal and so forth. There were 18% that were domestic
corporate on corporate, they remained in the listed market, there was 17.8%
that were foreign private, that would be Abu Dhabi buying PrimeWest, and so
forth, and there was 11.3% that was domestic private, that would be OMERs
taking out Golf Town, that would be PSPB taking out Retirement REIT. So $300
billion of transactions, or 18%, $60 billion remain in the public markets, so
an investor we are seeing a continued narrowing of our investment universe as
people take advantage of ineffective corporate taxation policing in Canada and
use the tax account to finance the takeover of business. So if you walk through
a thin capitalization structure on the CVRD Vale transaction, what you’d find
is that the payout of the equity piece back to CVRD Vale was somewhere around 3
years. If you model Potash being taken out by BHP Billiton, you got your senior
debt, you build your two thirds sub-debt, one third equity, the interest on the
sub-debt would in effect repay the equity slice in just under 4 years. We’re
patsies when it come to effective policing of capital structure and as a result
we’re losing our listed market.
When I started running conservative equity portfolios, 20
25 years ago, my typical portfolio would have had a Dofasco, would have had
Alcan, would have had a Seagrams, might have had a Molsons, would have had
Hudson’s Bay Company and would have had at times Potash would have had various
energy companies, and my Universe continues to shrink. As a middle class
Canadian who is looking forward to a retirement and I’m looking forward to a
retirement that includes a dividend stream, to restrict me to financials and
materials companies is a pretty shitty future. They’re either volatile or too
concentrated. There’s a lack of understanding in my view in Ottawa, of the
needs of the population and the populations savings.
I really do believe it is sheer ignorance. You’ve got
people who’s primary savings vehicle is a Public Service Pension Plan, they
don’t have responsibility for their own savings, dictating tax policy, have no
understanding of public markets, so they don’t care. Dealing with a Minister of
Finance who’s a professional politician. Most of them are not literate in
corporate stuff. And their only exposure is at the CEO level, as opposed to the
investor level, they don’t understand what I do for a living. They don’t
understand what anyone hired who handles private client money does for a
living. Now when they talk to Nixon or they talk to DeFMarais, or they talk to
Gwyn Morgan, they’re going to get a corporate view as to the role of retained
earnings, the role of reinvestment for growth and generally a very limited
understanding of what their retail investors are looking for, because they
don’t talk to the retail investors.
GL: I know Murray Edwards also had some sort of input
into this and I know he was involved in the SPP meetings in Banff etcetera. Is
there some sort of idea of levelling the playing field between Canada and the
United States with getting rid of income trusts?
FM: There would have been a bit of that, but it didn’t
level the playing field and quite frankly, I can go out and buy Enbridge LP in
the United States and have myself a Master Limited Partnership that owns US
infrastructure assets in the correct ownership structure. These are long
duration assets that you should not overcapitalize. You don’t need to take the
retained depreciation and rebuild a pipeline. It’s stupid and you don’t have
enough new markets to create a perpetual motion machine on that business.
GL: It’s a mature industry.
FM: That’s right, mature industries should be harvested
of their excess capital and allow that capital to be redeployed.
GL: You’d think that they’d understand that’s what
capitalism is about really.
FM: Unfortunately large businesses, CEOs like to control
capital and they believe that they are a better allocator of capital than
anyone else, well this unfortunately is an erroneous belief. The data that I’ve
got on reported earnings versus recurring earnings indicates that roughly 1
dollar in 5 of every reported dollar of earnings since the late 80s to now has
been subsequently been written off due to bad M&A activity and BCE alone in
that time frame knocked off alone some $20 billion of shareholder value. The
classic generation one income trust was a company called Canadian Oilsands and
it’s been around since 1995.
GL: Does Enerplus go back that far.
FM: Yeah, Enerplus goes back to 1988.
GL: That was one of the first ones.
FM: Yeah, and NCE Petrofund was 89, Pengrowth is 89, but
I prefer the Canadian Oilsands one, because it is essentially a passive
investment. What you have is an interest in the Syncrude facility and you don’t
have any real management.
GL: What do you figure Rick George’s role in this was?
Suncor just wanted to buy these oil and gas assets?
FM: I honestly don’t know what Rick George’s role was,
but I can tell you that from beginning of December 1995 to the 13th of August
2010, Suncor under active management had a compound annual return of 20%, it
was a good investment. Under passive management Canadian Oilsands had a
compound annual return of 25.2%, it was a better investment. And the TSX which
is supposed to be a growth investment, it’s return over that 15 year period was
11.7%. Over the decade ending December 2009, the income trusts as using the
Scotia Index outperformed the TSX by something like 600 basis points annually.
Releasing the trapped capital in mature businesses is a much better way of
running a business than trapping the capital and going out and buying shit.
GL: Right, which is, you know, is just kind of like a
hobby for these CEOs.
FM: It’s all tax policy and it’s tax policy that is
rigged in favour of large capital and rigged against small retail investors.
GL: What do you figure someone like Jim Stanford, the CAW
economist, was trying to do with his rants about income trusts going back to
2004 I believe.
FM: I don’t think he understood them and quite frankly I
don’t think that he understands capital markets.
GL: I don’t either because he keeps talking about how
buying a house is your best investment, but anyways. What about Diane Urquhart
and Al Rosen were they sort of like mercenaries to some sort of people?
FM: I’m not sure what Diane’s axe is. She’s a former BMO
research analyst, she was the research director at Scotia. She knows her way
around a balance sheet, she knows her way around an income statement.
GL: She has a CFA, so she should know those things.
FM: Yeah, and Rosen’s a very good accountant. What I
would say that both of them got fixated on was including the depreciation on an
asset in the distribution. Their belief was that that should be retained within
the business, you should only be paying out net income or less than net income.
I disagree with that on certain businesses. There is no reason why you should
retain depreciation on the Exchange Tower, unless you are prepared to go out
and build a new Exchange Tower periodically. Those are the first two new
buildings in the downtown core since the overdevelopment of the late 80s. It
actually needed new capacity, but when you need the new capacity you get the
capital together you don’t keep the capital for 25 to 30 years in anticipation
of the new investment 25 to 30 years down the road. Let that capital be
reallocated.
GL: Well their conclusion in the “Worst is yet to come” is
that there should be a distribution tax of 10%, now how is it that Flaherty just
flew right past that to 31.5%. Do you figure it was Mark Carney’s policy that
did it?
FM: Quite frankly, I don’t even consider this stuff. To
me you get income out of a business it’s being fully taxed in the hands of the
recipient of that income. Why institute a layer of double taxation? The only
reason you would institute a layer of double taxation is to attack the
retirement savings in RRSPs RRIFs and RESPs.
GL: Do you think that Flaherty was actually hoping to
garner more tax revenue or do you think that he was trying to kybosh or
sabotage the tax revenue for future governments.
FM: I think tax revenue is a red herring in this. At the
same time they put the trust taxation in place they eliminated withholding tax
on short term debt, they eliminated withholding tax on related party debt and
they gave tax treaty status to US LLCs which is what private equity firms use
to own their private equity investments. They enabled the transfer of pretax
income to move out of Canada to foreign direct buyers of Canadian assets
without any tax structure
GL: So they are tilting the playing field towards these
buyers.
FM: Very much so. Now I don’t know why this is being
done, it makes no sense to me.
GL: So is it like what Eric Reguly said that this was a
disastrous policy for Jim Flaherty?
FM: It’s not a disastrous policy for Jim Flaherty. This
is a policy direction that the government has decided to go down. They do not
want two listed entities with different tax structure. They only want one
listed entity with a corporate tax structure. They reduced corporate taxation
and they reduced the impact of double taxation through fixing partially the
dividend tax credit. So to me as a taxable investor, I should be absolutely
indifferent whether I get a trust distribution or a dividend from the surviving
the corporation. What they have done is eliminated the ability to get pretax
income into RRSPs and RRIFs for retail investors while still permitting private
equity to get access to that pretax cashflow. So they levelled the playing
field in the listed market, but they left an unlevel playing field in the
private market. So we are seeing assets flow out of the listed market into the
private market.
GL: So why wouldn’t they implement a policy like what
Dirk Lever was talking about, where you know, they do a sort of a hybrid with
Jack Mintz with a..?
FM: Any of these hybrid solutions leaves an unlevel
playing field in the listed market and they want only one listed vehicle, they
don’t want any MLPs, if they could get rid of REITs, they would get rid of
REITs. All they want is taxable entities in the public market. They want
capital retained within those businesses for growth and growth provides jobs.
They look at this as a job creation structure. It’s not a savings structure,
it’s not an income structure. They don’t care about that. What they want is
growth in the economy, growth in the corporations to provide employment.
GL: Do you figure they’re scratching their collective
heads or they’re shocked that they are losing tax revenue as a result policies?
FM: If you look at corporate tax revenue, they are not
losing corporate tax revenue. It’s clear from the fiscal tables that corporate
tax revenue remains at a fairly consistent level of GDP. So it’s maybe moving
around, it’s changing it’s nature, and new taxable entities are coming up while
old ones slip away, but in general the corporate tax revenue is pretty stable.
GL: They’ve basically rewired it so that the average
Canadian doesn’t access this capital?
FM: Pretty well. Now I had an interesting conversation
back in February with the Industry Minister Clement, it was at a lunch hosted
by *** Securities. He was there to talk about telecom policy, this was shortly after
Orascom’s subsidiary Globalive had been deemed to be a Canadian controlled
corporation. At the beginning of the meeting the Minister asked the audience, “What
would you do to increase tax revenues?” I piped up and said, “Enforce thin
capitalization rules.” He didn’t know what thin capitalization meant. He didn’t
understand the impact of capital structure on tax revenues. So hey, he’s a
Northern Ontario politician. He then made the comment that “Orascom sub
Globalive was deemed to be a Canadian controlled entity because the board and
management were predominantly Canadian.” I asked the question “Did you look at
the ownership? Did you look at the capital structure of Orascom?” “No we didn’t
look at capital structure.” I advised him that Globalive is a thin
capitalization entity controlled by a foreign company called Orascam, that the
majority of capitalization is by way of 18% debt, so any income that’s earned
is earned is paid out as interest on the debt and 18% debt pays out in
somewhere under 4-5 years, assuming you are compounding. That was like raising
a red flag to me. I then asked him the question, this was while the strike was
going on up in Sudbury. He’s the MP for that area, it’s a sensitive question.
“When you did the net benefit for Canada analysis of the CVRD/Vale takeover of
Inco, did you look at the impact on tax revenue that would occur if the capital
structure of Inco was changed.” And he said: “No we did not look at capital
structure, we only looked at jobs.” It is pretty clear through this
conversation that they’re not interested in what tax rate foreign corporations
pay in Canada.
GL: Just as long as they employ Canadians?
FM: So long as they employ Canadians. They don’t care
whether the ownership is in the public market or in the private market, so long
as the employment remains constant. And if the rules for the private market are
more tax friendly then the rules for the public market, you see assets flow out
of the public market into the private market.
GL: Well it’s like electricity flows in the path of least
resistance.
FM: That’s right. So the bid for Potash? Potash will be
restructured as a thin capitalization entity, it will flow it’s pretax cash
flow out of Canada. And a company that paid a billion dollars in taxes in 2008
is not going to pay taxes here anymore.
GL: In other words they’d make really bad electricians
these people.
FM: I think yes, you are going to see some short
circuits.
GL: Unbelievable. There is this theory that there is a
group of guys who lobbied for these policies and they got them, but how does it
benefit them now?
FM: They can control cash in a big corporation. Doyle at
Potash Corp according to the press is going to make $400 million on the
takeout. I know that the CEOs of Falconbridge, Inco, Stelco, Dofasco, all did
extraordinarily well on the takeouts, and you know the shareholders got paid
well.
