2010-08-19 Interview With Bay Street Fund Manager Regarding Income Trusts

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.