Income trusts have not been sold to help retired individuals meet their financial security in retirement; they have been sold for the revenue they generate for the financial institutions and the often phenomenal financially engineered returns for private equity and institutional investors who used income trusts as exit routes. The income trust IPO has been an exit strategy that has allowed cashflows and leverage, and hence valuations, to be manipulated in favour of private equity, corporate, and institutional sellers.
The decision to buy an income trust is principally a decision between current and future consumption and the decision between the rates of capital depletion and the rate of capital accumulation. Many trusts have been distributing not just return on capital but a good portion of capital itself. Many are also using debt and capital raised from new issuance to fund distributions in excess of cashflow, let alone earnings.
The yield on cash bonds and traditional equities is insufficient to meet the financial needs of all but the very wealthy. Individuals are forced to meet lifetime expenditure by depleting investment capital. It is this that has drawn the individual investor towards the income trust sector.
Unfortunately, income trusts have not been valued as lower capital growth or capital-depleting investments that are exposed to the economic and market cycle for their return and access to capital. They have been valued as higher growth, high-yield investments that are impervious to risk. With most income trusts having been launched from the bottom of the last business cycle and up through the current commodity-led boom, investors have been led to believe that they provide both high yield and high rates of capital growth over the long term. Given this belief, it is no wonder that the average income trust investor is up in arms.
Are income trusts a value to the economy? Canada does not have a consumption problem; it has a productivity, growth, and investment problem. An entity that leverages short-term consumption at the expense of long-term capital accumulation will exacerbate short-term inflation problems and impact long-term economic growth. Income trusts are cash generative businesses that invest in cash generative activities and acquire cash generative businesses. They're unlikely to invest capital in businesses that are not immediately accretive to cashflow. Their investment objective is therefore short term.
Some have pointed out that sales revenue and capital invested by income trusts have increased at a far higher rate than the economy at large. These figures ignore the fact that this sector of the market is growing strongly through IPO issuance and post-IPO acquisition and that much of this gain is due to the transfer of capital from other business structures, economic sectors, and asset classes. At any one point in time, resources are best allocated and managed by efficient, competitive, and informed markets without distortion. The efficient allocation of capital and the pricing of capital within the Canadian marketplace has been negatively impacted by tax distortions and by informational asymmetry.
Are they important to the Canadian resource sector? At a time when the world economy has seen overweight commodities and when global capital has been aggressively seeking exposure to commodity investments, it would seem absurd to state that the Canadian resource sector has been dependent on income-hungry Canadian investors. The problem Canada has is in allocating return from the resource sector to the rest of this economy.
Are they important sources of capital for small- to medium-sized businesses? I have analyzed the financial histories of 100 income trusts, from pre-IPO and conversion to the current point in time. The majority of the businesses at IPO that I looked at were not businesses seeking capital for expansion, but private equity and institutional investors seeking exit strategies for businesses acquired. Another important source of income trusts was large corporations spinning off non-core businesses or minority stakes to raise capital. Many of the genuine corporate conversions were companies that were grown well enough prior to conversion, that were retaining earnings, acquiring business, investing, and clearly had access to debt and equity capital. Companies with significant cashflow are also companies that are best able to finance their own organic growth and the least likely to suffer from the end of the income trust model.
Is there a real viable and valuable cost of capital? The lower cost of capital argument only works if capital is not transferred to institutional or private equity sellers but retained for organic growth or for an acquisition strategy that does not value its targets on a similarly distributable cash multiple. There is evidence that income trusts are paying higher multiples for their acquisitions. Clearly, the cost of capital for an income trust in the marketplace is so high that they can only meet this cost through a return of investors' own capital.
Does an income trust structure pose greater fiscal discipline? From my analysis, it would appear that far too many income trusts have been raising capital far too easily. At the same time, with valuations and the ability to raise cash dependent on the maintenance of high cash distributions, many companies are forced to maintain the cash distributions at levels well beyond those the business is capable of maintaining.