21 July 2007
Private Equity Raises Ghosts of Income Trusts Past
Just when the federal Conservatives had started to put their
income trust flip-flop behind them, along comes news of Brookfield Asset Management trying to design a leveraged buyout of
Canadian Pacific Railway. Private equity's rampage across Canada, from Canadian sources or not, is provoking much the same discomfort
in Ottawa circles as income trusts did last year - discomfort about the effect of a major restructuring of corporations on tax revenue,
productivity, and the national interest. Brookfield's advances may poke a stick in Ottawa's eye.
On the surface, a Brookfield-led leveraged buyout of CPR should not raise many eyebrows in Ottawa.
It would be an all-Canadian deal, so thorny foreign ownership and hollowing-out issues wouldn't raise their
heads. Consolidation is not a problem with this type of deal, either. Transport Minister Lawrence Cannon has a say in any such deal,
but there are no immediate reasons for him to flex his muscles. After all, his government has gone to great lengths to tell the private
sector that free markets should prevail.
But the Brookfield proposal - whether it materializes or not - exposes some serious policy issues that Ottawa has skirted till now.
Leveraged buyouts have become the takeover structure of choice in Canada and elsewhere, and they are changing the corporate landscape
in a way that demands close scrutiny from policy makers.
The federal government has expressed its concern about the rampant foreign takeovers of high-profile Canadian companies
that have prompted fears of the "hollowing out" of Canadian head offices. An expert panel has been formed to look at whether
Ottawa should be more selective in allowing foreign takeovers.
And Finance Minister Jim Flaherty is in the midst of setting up a separate expert panel on international taxation, to make sure
Canada's laws don't inadvertently allow companies to avoid paying corporate taxes.
But neither of these panels will lead to action any time soon, or even in the medium term. More importantly, these panels represent
Ottawa's main reaction to the merger-and-acquisition boom, and are one of the few concrete measures the federal government
has taken to make sure Canada is prepared for globalization.
And yet both panels neglect to confront the driving force behind much of the reshaping and restructuring of companies these days:
highly leveraged buyouts.
National Bank Financial calculates that 89 percent of the merger-and-acquisition activity in Canada so far this year has
been financed by cash. That doesn't mean that 89 percent of the deals were leveraged buyouts, but it's a reasonable proxy, economists
at NBF say.
The proportion of cash deals has been rising steadily since 2002. Some analysts may argue that private equity is cyclical, usually
rising when markets are strong, and dropping back when markets are weak. But compared with the previous peak of leveraged buyout
activity, in 1999 just before the tech wreck, today's activity is nothing short of phenomenal.
The Brookfield-CPR idea reveals the elephant in the policy room. It strips away the concerns with foreign ownership and
hollowing out, and instead, highlights questions about how appropriate the prevalence of private equity is for taxation, corporate
accountability, investor choice, productivity, and the national interest in general.
In short, the prevalence of private equity is turning out to be the income trust debate in a new guise, complete with its
hard-to-find solutions.
Are leveraged buyouts, like income trusts before them, set up specifically as tax avoidance schemes? Are they used to finance
acquisitions by putting massive amounts of debt on the books of entities, like pension funds, that don't pay much corporate tax?
Are private equity deals designed to slash and burn, to chop up national treasures into chunks that are profitable in the short run but
unworkable in the long run?
Are so many Canadian firms succumbing to private equity deals that shareholders looking for investment opportunities on the Toronto
Stock Exchange will find their choices diminishing to a point where their portfolios are about as Canadian as the NHL?
With key Canadian infrastructure companies such as Bell and CPR in the crosshairs of private equity firms, will the integrity of
Canada's economy be in question? With fast, high returns their only motive, will such companies be responsive to public or political
pressure to act in the national interest? And at the financial level, does the taking on of huge debt put the lenders increasingly at
risk, especially in an era of rising interest rates?
"Any investor lucky enough to hold shares of a company being acquired will tell you that it feels a bit like winning the lottery.
However, as is the case with many things, taken to excess, they do more harm than good," National Bank Financial concludes in its
recent analysis. "When the dust settles, the current M&A boom may turn out to be like a credit card shopping spree:
instantaneous gratification but financial stresses down the road."
The Bank of Canada monitors these types of financial stresses regularly, and says the balance sheets of Canadian financial institutions
are in fine shape, no need to worry. But beyond that pat and predictable answer from the central bank, the discussion around the
broader issues of private equity is in its infancy in Ottawa.
Even the expert panel on foreign ownership was a reluctant afterthought added on to a previously announced review of competition
policy, lumped into the review mandate as public pressure rose.
The ministers of finance and industry are only just coming up for air after dealing with their income trust debacle and confused
communications over how they would eliminate interest deductibility of debt borrowed to finance foreign acquisitions. They have yet to
connect the dots about how the prevalence of private equity will shape Canada's economy and affect tax revenue.
But if Brookfield and CP Rail ever reach the point of sending their emissaries to Ottawa to sort out how best to get a deal done, the
magnitude of such a Made-in-Canada takeover will definitely force the issue.
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