October 14, 2006
Income trust conversions, virtually a novelty five years ago, have ballooned to almost C$65 billion in value in 2006 as an increasing number of large-capitalization companies are drawn by the promise of these tax-efficient structures. In the process, investors are getting their hands on a bigger chunk of Corporate Canada's cash flow than ever before.
The very inflexibility of the income trust structure explains much of its appeal. What started as a way for small companies to cut their tax bills has become something else: a tool for shareholders to reclaim some of the discretion that once belonged almost exclusively to CEOs and directors, and at the same time address a lack of faith in corporate executives to spend their excess cash wisely.
Trust conversions, in other words, may come to represent one of the biggest power shifts between investors and management that Canada has witnessed in a generation.
Indeed, one of the reasons shareholders have gravitated toward trusts is that they function as a kind of a leash on executives bent on sacrificing upfront, predictable profits in their core business in favour of empire-building or diversification. Trusts pay out the bulk of their cash to unitholders and are in essence forced to ask permission from investors every time they want to raise money for a large acquisition.
Not everyone is sold on this line of thinking. Detractors argue that income trust structures deprive the government of corporate tax revenue, and that by imposing a "leash" on executives, Canada could be headed for a massive productivity problem. Economic nationalists also worry that stricter controls on deal making could deprive the country of the chance to create global champions.
The trust market can indeed be a stern taskmaster, and it expects its cash distributions to be made routinely, with no exceptions. If a regular company has a bad quarter, or makes an acquisition that doesn't pay for itself within a prescribed time, it can typically soldier on. A trust's problems are more transparent and one bad deal can force management to cut distributions. When that happens, the punishment is usually swift.
"It's not surprising, given both the strictures and the immediacy of the market's response," says Phil Brown, "that senior management at many companies are reluctant to ponder a conversion." Many are fearful of taking the plunge because of the demands to pay out consistent cash flow and the tighter constraints on acquisitions. "Becoming a trust doesn't actually handcuff management. All it does is force them to go back to the institutions and the ... retail market and have them bless the transaction."