Canadian Income Trusts: PEs gain massive buyout opportunities but lose significant exit vehicle on government decision - analysis02 November 2006

The splash caused by Canadian Finance Minister Jim Flaherty's proposed tax on income trusts will send waves of potential M&A opportunities rippling across the Canadian market. Flaherty's announcement after markets closed on Halloween that trusts would be taxed has taken the floor out of the market, with the majority of these TSX-listed flow-through entities trading down 15% to 20% already, and moving lower.
According to the announcement, newly issued trusts would begin paying taxes next year, while the rest of the trust universe would be given a four-year grace period, remaining exempt from any taxation until 2011.
"Every single business trust is up for sale," said one industry source, "there will be massive consolidation in the sector - high quality trusts will have to revert back to regular corporate structures and assume high amounts of corporate debt, while private equity will be swooping down to buy what's left over."
However, one private equity source was more cautious. "We'll see some M&A driven by the PE side, but they're going to want to wait for things to settle down," he said, explaining valuations have yet to settle post-announcement.
"Most private equity firms prefer to do friendly deals," he added, explaining that private equity usually rely on a core of management to stick around and operate the bought-out entity," and at this point boards are just plain shell shocked and not likely willing to talk to anybody." Having said that, the source admitted that although no deals are expected to happen today, "over the next quarter there will be heightened activity."
"Valuations were down 15% - 20% yesterday, and another 5%- 15% today - they're getting knocked very low," the first source said, explaining that even the fund of funds - retail driven instruments such as mutual funds which are heavily invested in trusts - have stopped "bottom fishing" and are being forced to sell in order to pay off the redemption rights of their investors. "That's going to take a bit of time to shake out, but it won't work in their [the income trusts] favor," the source explained.
The source pointed to names like Arriscraft International Income Fund, CanWel Building Materials Income Fund, Gienow Windows and Doors Income Fund, Richards Packaging Income Fund, Stephenson's Rental Services Income Fund and Strongco Income Fund as vehicles that were "already underperforming" that will be the prey of private equity buyers. None of the named companies returned calls to comment.
The PE source pointed to names that have already been hit by the decline in housing starts, which are now doubly suffering from the recent announcement, as potential targets, such as The Brick Group. "They sell furniture and appliances, and when people stop buying houses they generally stop buying furniture," the source explained. The Brick Group did not return calls to comment.
However, even "high quality names" in the Income Fund sector are expected to be targets. The first source pointed Teranet Income Fund and Yellow Pages Income fund as two "high quality names" that have fallen dramatically in value. "Teranet is trading at 8 times earnings - but we figure they should easily be trading at 11 times - now that’s a significant opportunity," the source said. Teranet Income Fund and Yellow Pages Income did not return calls to comment.
The second source though pointed out that although private equity does have a good opportunity to pick up targets, they have also lost a significant exit vehicle. "Yellow Pages was bought by private equity and then spun back out as a trust, which is the case in a lot of these deals," he said. "Now that a significant exit vehicle has been taken away, where do they go?"
In the case of Yellow Pages, a case could be made for media companies to be buyers, he said, but "these kinds of questions are definitely being raised, and will affect future buys."
Meanwhile an industry lawyer countered that companies who have only just announced plans to convert into an income trust will be scrambling to find out what to do next. "Companies in early and final stages of becoming an income fund have had the rug pulled out from under them," the source said. "So we might see more IPO's and more M&A immediately as a result in these cases."
The second source said that these entities could instead look at reverse takeovers (RTOs) as a way of dealing with the crisis for now. "Some options would include selling into an existing trust, or even an RTO to take advantage of at least four years of income trust status," the source explained. "Buy up a trust like Spin Rite or Associate Brands, sell off the assets, then hold on for 4 years and wait for a better mouse trap," he said. Spin Rite Income Fund and Associated Brands did not return calls seeking comment.

Sources interviewed agreed there will be a temporary moratorium on acquisitions made by trusts, a trend that could potentially affect the pricing of targets in industries such as oil and gas. "There's no question, trusts are definitely going to have to shut down for a while," the second source said, "and that will tighten the pool of bidders in certain industries."

by Alex Welsh

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