On the rare occasions that the U.S. looks to Canada for inspiration, the results are usually encouraging- nobody can argue with Canadian bacon or hockey. The financial community has also taken notice, and clones of Canada’s Income Trusts have started cropping up in the U.S. and Europe.
CIBC World Markets is the bank credited with importing the product, known as income deposit securities (IDS), which made their debut in December. The Blackstone Group and GE Capital were the first to float IDS units in their IPO of portfolio company Volume Services, and based on the number of IDS filings since the IPO, it is safe to assume they started a trend. Blackstone, however, declined comment for this story.
In the U.S., the IDS could probably qualify as a second cousin to the Real Estate Investment Trust (REIT), in that the structures of both the IDS and the REIT are prized for their tax efficiency. The IDS is a hybrid structure, combining the common stock and debt of a business into a solitary unit. The units yield a fixed interest rate to investors, possibly as high as 11% according to some estimates, and have the added bonus of paying a dividend on the company’s stock. Also, the subordinated debt attached to the unit makes the interest payments tax deductible.
The standard IPO has almost always been the darling of venture capitalists, rewarding high growth stories for their profit swells and potential future growth. The IDS structure, meanwhile, should play perfectly into the companies buyout players typically invest in; the slow, steady growers, with consistent and predictable cash flows. The issuers of these units pay out all of the excess cash flow rather than retaining the capital to fund new growth, preserving a level of leverage that is sustainable and quasi-permanent.
Some buyout investors in the U.S. have already gotten a taste of the product. The income trust in Canada has spawned a roughly $90 billion market, and a number of U.S. buyout players have been quick to test the waters up North. Kolhberg Kravis Roberts & Co. and Teachers Merchant Bank floated the former Bell Canada Yellow Pages business as an income trust, a deal that yielded substantial profits for the investors, while Centre Partners accessed the market by merging its Bumble Bee Tuna portfolio company with existing trust, Connors Bros. Income Fund.
Since the Volume Services floatation in December, other U.S buyout shops have been jostling to unload their own portfolio companies through the structure. For a buyout industry that has been starved for exits, the IDS couldn’t come soon enough. Centre Partners-backed American Seafoods, Bruckman Rosser Sherrill & Co.’s B&G Foods, GTCR Golder Rauner portfolio company Coinmach and Apax Partners investment Xerium are all among those that have unfurled their own IDS filings. Most recently, Thomas H. Lee Partners filed to float IDS units of Eye Care Centers of America. Other firms with portfolio companies that have filed to float as an IDS include Fox Paine & Co., Kelso & Co., Apollo Management, Citicorp Venture Capital, Pegasus Capital Advisors and MSD Capital, among others.
In Europe, the IDS structure has also touched down. Texas Pacific Group will likely be the first to introduce the product outside of North America with the floatation of Findexa, although the IPO date has been pushed back due to market conditions. In Europe the product is known as High Yielding Dividend Shares (HYDS).
Thad Johnson, a director at Merrill Lynch Capital, in a March roundtable discussion sponsored by SSG Capital Advisors, described why the IDS structure is so appealing for LBO players looking to exit. “These Trusts provide exceptional opportunities for owners of businesses who want to be able to exit with cash. The one we were pitching, the sponsor bought this business four months ago at a just over 6x multiple. And four months later their exit will be at a 10x multiple. It’s off the charts. And by the terms of the product, they still retain a 25% ownership interest in the residual company, and their exit is in cash. Yet they get a 3.5x to 5x return on their basis.”
From the individual investors’ perspective-the side that will buy these units-the appeal lies in the market’s current craving for yield. Lacking expectations for chart-topping growth, which will fuel the likes of Internet offerings such as Google and biotech prospect Memory Pharmaceuticals, the companies that should fare best as an IDS will be marked by slow, predictable growth. And with baby-boomers entering retirement, dividend-generating investments should have no shortage of suitors. Early estimates expect the U.S. IDS market to reach $12 billion in just a few months, according to published reports.
One buyout pro familiar with the IDS says, “There is a lot of investor appetite for these things. It’s all anyone wants to talk about. Their emergence matches up companies that have the ability to consistently generate free cash flow with investors that want to invest in a cash generation business.”
The Tax Man Taketh?
Even as the IDS represents a potential godsend for buyout investors looking to exit, there are some questions that still remain. First and foremost, is how will the “Tax Man” treat the subordinated note element of the IDS, and whether the interest expense on that component is truly deductible. Nearly everyone outside the Internal Revenue Service believes it is, and most assume that the IRS will agree. Staying in character, the IRS has been mum on the subject.
The uncertainties arise because since the equity and debt consist as one entity, it begs the question of whether the debt is in fact marketable by itself. A source explains, “If you can demonstrate that someone is willing to buy the debt alone at the same price, then you know the investor is not just buying it because it’s attached to the equity.”
Fears that the IRS will not honor the assumed favored tax status of the IDS structure are starting to arise. Volume Services, after an initial pop following the December offering, has seen weakness because of these reservations. The stock, after reaching a high of $17.80 a unit in January following its IPO, is now trading below its initial offering price and has reached a low of $14.00 per unit, more than 8% below its close on the first day of trading. Even stronger-than-expected Q1 earnings could not buoy the unit.
However, most believe these fears are unfounded, since holders of Volume Services’ IDS units and future offerings, can and will be able to separate the equity and debt portions. Also, the structure has been approved by nearly every other entity with an opinion. CIBC World Markets, in a research note to clients, chimes in, “The structure was taken to Washington D.C. and explained to officials at the IRS and the Treasury Department last March, with follow-up meetings having taken place since. We believe that if the IRS had a fundamental issue with current treatment of the IDS structure it would have raised an issue at some point last year.”
A buyout pro that has looked at the structure adds, “The Volume Services deal has not been challenged yet… There can be 10 of these things that get done and the IRS can still change its mind, but it’s now six months since Volume Services has priced the deal and a lot longer than that since they filed it, so most feel pretty comfortable by now.”
To be safe, though, Goldman Sachs introduced a structure for future IDS offerings that would sell 10% of the subordinated notes separate from the IDS units. The unattached notes, known in banking circles as bachelor strips, are designed to prove that there is in fact a separate market for the debt security.
Another question that lingers as investors eye future offerings, is whether the market’s appetite for yield will sustain itself in an environment where interest rates are poised to start heading upwards.
Thad Johnson, in a follow up call, tells Buyouts, “So few [IDS IPOs] have been done, so there’s no clear picture yet on how these issues are going to trade or how they will perform in a period of rapidly rising interest rates. One can speculate that these will trade very much like a REIT.”
REITs, for the record, have been gasping against the backdrop of a potential rise in interest rates. As of mid May, the S&P REIT index is down more than 8% year to date, and following economic data released May 7, showing a better-than-anticipated rise in job growth for April, the index slumped 3.5% on the good news.
Friend or Foe?
Buyout players are likely licking their chops at the opportunity the IDS structure presents, especially following a barren stretch for LBO exits. However, the same people who are today calling the IDS a blessing, could soon be cursing the structure and the bank it rode in on.
In Canada, the income trust has emerged as a major rival to buyout firms. Companies that fit the buyout profile – the same good’ companies that would probably attract 10 to 15 LBO bidders in an auction are now skipping right past the sponsors and filing directly for an income trust.
Earl Rotman, a vice chairman at CIBC, which masterminded the structure, told Buyouts in April, “It’ll be interesting to see what the impact will be on the buyout market. There has been a lot of activity where corporates go to private equity and are then sold into an income trust. But now it could turn into another play where corporations bypass private equity altogether and go straight into the income trust market.”
James Leech, senior vice president at Canadian heavyweight Teachers’ Merchant Bank, echoes that warning. “The trend [towards income trusts] has been huge [in Canada] the last two years. But we’re finding that while it’s a great source for exits, it also represents a major competitor [when buying companies]. We’ve certainly lost some transactions to that market.”