NEW YORK -- Finance Minister Ralph Goodale's intervention in the income trust market has led to an RCMP investigation and an election-related political backlash, but it also undermined the market at a crucial time for one Toronto company.
Somerset Entertainment Income Trust was forced to scramble -- and existing unitholders had to accept greater dilution -- to salvage an acquisition of a U.S.-based rival.
Somerset chief executive officer Andy Burgess and his Canadian investment bankers had spent months last summer convincing a skeptical Minneapolis-based Compass Productions Inc. about the virtues of the trust structure, only to see Somerset's unit price tank when Mr. Goodale mused over the fall about revamping the system.
The RCMP is now investigating Mr. Goodale's office for allegedly leaking word that the Liberal government would leave the system intact, provoking cries of scandal from opposition politicians on the election campaign.
Somerset, which produces and distributes specialty music through retail displays, managed to close its $51.8-million (U.S.) acquisition of Compass just before Christmas, but only after intensive negotiations and sweeteners to keep the deal on track.
Mr. Burgess said Mr. Goodale's timing couldn't have been worse, but he added that the ultimate success of the acquisition is an indication of the strength of Canada's income trust market. The minister's announcement that the government intended to review the trust sector's favourable tax treatment came just days after Somerset and Compass signed their letter of intent in early September.
Under the deal, Compass would receive $37-million in cash, the rest in Somerset units; the total included future payments dependent on the merged entity's performance.
Mr. Goodale's confirmation the tax benefits would remain in place came just days after Somerset priced a $32.5-million (Canadian) offering of units to finance the acquisition.
In the eight weeks between the signing of the letter of intent and the pricing of the offering, Somerset's units fell to $7.50 from $9.50 on the Toronto Stock Exchange, reflecting the carnage in the trust sector more broadly. To keep the deal alive, Somerset increased the number of units it was willing to pay to Compass shareholders.
Even with the dilution, Somerset's acquisition raised cash available for distribution on a pro forma basis for 2005 by 16.3 per cent -- to $1.21 from $1.04 a unit, Mr. Burgess said in an interview last week.
Keith Harrison, Compass CEO and lead shareholder, said his board saw little choice but to consummate the deal, given Somerset's willingness to sweeten the pot. The government's intervention "almost hurt the deal, but we looked at it, and as things kept going along we had plenty of time to think and said: 'We're going to take a risk here and go for it. There's too much invested in this [trust market]; we don't think the government is going to let this thing fall apart'."
Mr. Burgess said he first approached Compass in late May but couldn't pursue a deal because Compass had an exclusive letter of intent with another company. But that exclusivity expired in July, and Somerset went to work educating Compass about Canada's income trust structure.
"These guys were not predisposed to a public entity other than a traditional public company," he said. "Even now, I'm not sure I ever convinced them that it is not some crazy Canadian home-grown capital structure."
Mr. Harrison and his advisers travelled to Toronto, where they learned that about 200 companies have listed as income trusts on the TSX, with a combined market capitalization of between $160-billion to $170-billion.
Mr. Burgess said the income trust sector has been wrongly criticized as stifling growth. While that may be true for companies that need big capital expenditures, others can finance growth by issuing new units, and benefit from the discipline imposed by the financial market.
"The income trust structure makes more sense because there is a discipline and constraint on management to not do silly stuff with the extra cash generated," he said. "For me, the whole discipline of knowing that we would have to go to public market made me be sure that the acquisition met a higher standard than perhaps it would have otherwise."
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