Merger mania in the income trust sector? Not for the dregs
The Globe & Mail, Wednesday, March 21, 2007
Streetwise: Takeovers
Andrew Willis
Conventional wisdom has private equity funds on the verge of a buying binge in the beleaguered business trust sector. Conventional wisdom just might be all wrong.
There's an emerging school of thought that says the private equity players, with their supposedly insatiable appetitive for deals, are going to steer clear of trust acquisitions for the foreseeable future. To understand why, look no further than Granby Industries Income Fund.
There aren't many players in the steel storage tank sector. Granby is an Eastern Canadian leader in the field, with 50 years of experience building home heating oil containers. It went public as a trust in 2004 when it was spun out by private equity fund Torquest Partners.
In the West, the very short list of tank-making heavyweights includes GLM Tanks & Equipment, an Edmonton-based company that was bought in 2006 by one of Canada's most experienced private equity funds, CAI Capital Partners.
Granby was a $74-million company when it went public. Like many small-capitalization trusts, Granby has struggled. The federal government's decision to nuke the sector in October knocked the already depressed price of units back by a third. Granby now has a $26-million market cap.
So Granby's cheap, right? And a logical takeover target for GLM, backed by CAI's $1-billion war chest?
Don't count on it. A look at the numbers shows that like many trusts, Granby is still trading at a far higher price than the typical private equity fund is willing to pay. The enterprise value of the Quebec company — equity plus debt — is still 8.8 times earnings before interest, taxes, depreciation and amortization, or EBITDA. That's too expensive by a half.
Successful funds such as CAI prefer to make their living by picking off companies at four to five times EBITDA. These investors pride themselves on being disciplined. At 8.8 times EBITDA, most private equity funds are sellers, not buyers.
So yes, it's true, many trusts have seen their prices slide in the wake of Ottawa's crackdown. But the fact that most trusts still deliver a steady stream of cash distributions, which support unit prices, and boast a tax efficient structure through 2011, means that valuations remain on the expensive side for private equity funds.
The cheapest trusts are those that have cut cash distributions. However, many of these trusts are now inexpensive for a good reason: They are lousy businesses with poor prospects. Private equity funds, like any successful investor, try not to make a habit of buying crappy companies. This was one of the points made by RBC Dominion Securities trust analyst Rajan Bansi when he poured cold water over the idea of trust takeovers in a report this week.
Mr. Bansi observed that the private equity crowd targets 20 to 25 percent annual returns when they put their money to work. Most trusts are mature businesses; they don't hold this kind of growth potential.
Screening the trusts for private equity targets means going well beyond the price of their units. It means finding companies with management and margins and prospects that are superior to those of peers. It means figuring out how those companies could be improved, and eventually sold.
Mr. Bansi looked at the credit market. Loans have never been cheaper, or easier, to get. The analyst reasoned this makes trust buyouts less likely, rather than more. He said that since risk has been repriced, it's now easier and cheaper to borrow money for any venture. That means "private equity investors will look beyond the returns available from business trusts; they will instead focus on riskier, perhaps more unconventional assets," Mr. Bansi said.
"We do not believe the unit price declines recorded for most business trusts to this point have created enough upside potential for private equity investors to become involved," he concluded.
This is not to say that buyouts won't come. Private equity has already stepped up, most notably in Harbinger Capital Partner's $802-million purchase of Calpine Power Income Fund. Strategic buyers have also swept in to buy rivals —witness the bidding war for Great Lakes Carbon Income Fund.
The point is simply that the cheapest trusts are not going to be the first to go. They may well be wallflowers in the takeover dance. Mr. Bansi's advice to investors is to look at opportunities on their own merits, given individual risk tolerance, rather than second guessing the likes of CAI Capital Partners. The best trusts to own are likely the quality trusts, where the unit price rises on the back of steady distribution increases, and any private equity takeover premium comes as icing on the investment cake.