FAITH THROUGH CONVERSION

Wade Burton, a man who controls more of BCE Inc. than almost anyone else, had a dilemma: Should he take on Michael Sabia, or let him be?

It was late spring, weeks before the telecom company's June annual meeting, and Mr. Burton, who manages billions of dollars for Cundill Investment Research, was losing patience. He wanted a radical restructuring, something that would pump some life into a stock that had lain dormant for years. But he wasn't sure about throwing the firm's weight, and its 26 million shares, behind an investor proposal to make BCE an income trust. Mr. Sabia opposed it, as did BCE's board -- a corporate who's who list that includes Paul Tellier, Richard Currie, Jim Pattison and Tony Fell.

Mr. Burton sat down to discuss it with a group of Cundill managers and analysts. "Let's just let Sabia handle it," he told them. Their reaction was unanimous. "Everyone on my team -- which is six of them -- said, 'You're crazy, Wade. Let's income-trust this thing today.' "

The ballot failed, despite Cundill's "yes" vote and the efforts of Toronto-based AIM Funds Management Inc. to stir other mutual funds and large institutions to back the idea. But the trust advocates had gained some momentum, and as BCE's stock drifted to a four-year low this summer, both investment firms continued to turn up the heat. Mr. Burton phoned Mr. Sabia to press the case, but the chief executive officer gave little ground.

Until this week, in fact, when Mr. Sabia announced the creation of Canada's largest income trust, the company had argued that the telecom business was changing too rapidly for management to adopt such an inflexible business structure.

But the straitjacket, for many, explains much of the appeal of the almighty trust. What started as a way for small companies to cut their tax bills has become something else -- a tool for shareholders to reclaim some of the discretion that once belonged almost exclusively to CEOs and directors, and at the same time address one of their deepest concerns: a lack of faith in corporate executives to spend their excess cash wisely.

Trust conversions, in other words, may come to represent one of the biggest power shifts between investors and management that Canada has witnessed in a generation.

"There are people who run businesses in Canada who think they own them. CEOs are important. You need them. Everybody loves them, admires them. But that doesn't mean it's their business," said Mr. Burton, whose firm is now part of Mackenzie Financial Corp. "What was clear to me was there was a lot of inefficiency in Canada. Management's ability to listen to reason is less than I would have expected from a developed, English-speaking, supposedly capitalist country."

BCE may have had more than its share of high-profile acquisition nightmares -- think of the billions of dollars in writedowns on Teleglobe Inc. or the tangential investments in TransCanada PipeLines Ltd. and an assortment of real estate, computer services, and financial companies -- but it is by no means alone. Countless Canadian companies have hoarded cash, only to plow it into bad deals, or businesses that have little, if anything, to do with their core operations.

Indeed, one of the reasons shareholders have gravitated toward trusts is that they function as a kind of a leash on executives bent on sacrificing upfront, predictable profits in their core business in favour of empire-building or diversification. Because trusts pay out the bulk of their cash to unitholders, they are forced, in essence, to ask permission from investors every time they want to raise money for a large acquisition.

"This is why I've owned trusts for 10 years," explained Sandy McIntyre, a trust proponent who is a senior vice-president at Sentry Select Capital Corp. "I lost faith in the capability of Canadian management to allocate the capital trapped in Canadian companies half a generation ago. They've done a truly pathetic job."

Since 1980, Mr. McIntyre pointed out, the reported profit from Toronto Stock Exchange-listed companies has increased just 5.7 per cent, while the growth among Standard & Poor's 500-stock index companies is only marginally better, at 6.2 per cent: not exactly stellar returns. One of the main reasons for these meagre returns, he suggests, is executives misspending capital.

"The amount of savings of the Canadian population that has been destroyed in ill-advised investment and M&A activity by Canadian management is criminal."

Of course, not everyone is sold on this line of thinking. Detractors argue that these structures deprive the government of corporate tax revenue, and that by imposing a "leash" on executives, Canada could be headed for a massive productivity problem. Economic nationalists also worry that stricter controls on deal making could deprive the country of the chance to create global champions.

Brian Gibson, a senior vice-president at the $96-billion Ontario Teachers Pension Plan, insists that capital allocation is a bigger concern than the perceived threat to productivity. Indeed, sources said Teachers, one of Canada's most powerful investors, had been quietly persuading BCE to consider the trust model for the past year.

"The biggest problem we have is poor reinvestment of capital," he said. "And there are a lot of businesses that are in a corporate structure that have not done well, and it has to do with the management not being very good at reinvesting the capital in new things. The advantage of a trust structure is that the bulk of the earnings and cash flow are paid out, and if management wants to seek an acquisition or something like that, they in effect have to ask the shareholders for the capital."

Leslie Lundquist, a trust expert and portfolio manager at Bissett Investment Management in Calgary, said she has faith in Canadian executives and is sympathetic to their plight. Yet she also understands why so many investors would prefer to have management under a firmer rein.

"I think if you look back, historically, it was suggested that Molson should convert to a trust, and they decided to go into Brazil instead. Look how that turned out. If you look back at Manitoba Telecom, they were tapped to convert to a trust, and they bought Allstream instead. I think maybe people underestimate how hard business is, how hard it is to go out and generate good internal returns that justify the risks you are taking."

The trust market can be a stern taskmaster, and it expects its cash distributions to be made routinely, with no exceptions. If a regular company has a bad quarter, or makes an acquisition that doesn't pay for itself within a prescribed time, it can typically soldier on. For a trust, however, the problems are more transparent, and one bad deal can force management to cut distributions. When that happens, the punishment is usually swift.

"The only thing more miserable than an investor who's just had his distribution cut or eliminated -- the only thing more miserable than that that I'm aware of on this planet is a woman scorned," said Michael Heier, founder and head of Trinidad Energy Services Income Trust, which runs drilling rigs. "The retribution is immediate and forthwith."

It's not surprising, given both the strictures and the immediacy of the market's response, that senior management at many companies are reluctant to ponder a conversion, said Phil Brown, a lawyer at Torys LLP who works on trusts. He said many are fearful of taking the plunge because of the demands to pay out consistent cash flow and the tighter constraints on acquisitions.

"This is why I knew [the trust concept]was a winner: The people that hated it most were the managements," said Paul O'Neil, a Canadian who helps manage money for Omega Advisors, a large Wall Street hedge fund. "And isn't that funny? This has made them more accountable."

Yet many CEOs who have made the transition from public company to income trust actually do like the added level of discipline -- even if it means having to get approval from investors for a major purchase.

"I don't have a problem with that," said Keith Carrigan, CEO of BFI Canada Income Fund. "We've been to the market several times and we've never been turned down."

BFI, along with the much larger Yellow Pages Income Fund, is among several income funds that have been voracious acquirers.

Still, Mr. Carrigan acknowledges that he was wary of the income trust structure when BFI went public in 2002, precisely because of doubts about its growth prospects.

"My initial question was the same question that you are asking today: 'How are we going to grow?' " he said.

"There are no texts you can read that say 'Here's how you grow through an income trust, follow this formula and this step-by-step approach.' We've learned our way through it."

Trust CEOs insist they can grow in much the same way as regular companies, although they acknowledge they face a pair of special challenges.

Rules prevent most trusts from having more than half of their units in foreign hands, which can complicate a significant cross-border deal that has to be funded almost entirely with equity. Managers of income trusts have also had to learn that the structure sometimes bars the door to buying money-losing companies, since this could hurt their ability to pay distributions.

"Maybe there's a competitor that goes bankrupt, and it might be very wise for us to buy those assets," said David Cynamon, CEO of KCP Income Fund, which makes consumer products such as bleach. "As a going concern it's not profitable today but it would be very strategic to buy. Unless our distributable cash is low enough that we can afford to buy it and not have any income from it for a little while, we'd probably have to pass."

The problem for many income funds is that their payout ratios -- the percentage of their cash flow that they distribute to investors -- are high and that leaves little wiggle room if a company they buy doesn't add to earnings. Now, as investment bankers and investors wise up to the implications of payout ratios that were hovering close to 100 per cent, new trusts are coming to market with a substantially lower distribution burden -- and substantially greater flexibility.

So, are investors right to believe that they are going to get more disciplined management in a trust? Yes, said Mr. Heier of Trinidad Energy, which converted from a common-share company to a trust in 2002.

"The way a management team thinks under the trust umbrella versus the way they think with a straight equity [company]-- it's two different thought processes," he said. "Being a trust is just like having a mortgage sitting on your house. The first thought every month is how you are going to make your mortgage payment. So now you are actually forced to focus on doing what's best for the guy who's invested in you."

Still, converting to a trust isn't a foolproof way to guard against bad management. It just exposes them faster to the wrath of the market, which may mean they are less likely to stay in the executive suite.

"Even with that discipline you can fool yourself on the synergies, on the strategy, and even the due diligence on the acquisition and make it appear accretive to yourself and the rest of the world -- and make the wrong deal," Mr. Cynamon said.

"It should be more disciplined, it should make it tougher, but boy -- management in most public companies have a way to convince boards and investment bankers and funds that it's the right deal. And when the world's a greedy place, everyone convinces themselves it's the right deal. But the penalty of an income trust is really early and much greater."

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There are people who run businesses in Canada who think they own them. CEOs are important. You need them. Everybody loves them, admires them. But that doesn't mean it's their business.

WADE BURTON

CUNDILL INVESTMENT RESEARCH

I lost faith in the capability of Canadian management to allocate the capital trapped in Canadian companies half a generation ago. They've done a truly pathetic job.

SANDY McINTYRE

SENTRY SELECT CAPITAL CORP.

I think maybe people underestimate how hard business is, how hard it is to go out and generate good internal returns that justify the risks you are taking.

LESLIE LUNDQUIST

BISSETT INVESTMENT MANAGEMENT

The advantage of a trust structure is that the bulk of the earnings and cash flow are paid out, and if management wants to seek an acquisition or something like that, they in effect have to ask the shareholders for the capital.

BRIAN GIBSON

ONTARIO TEACHERS PENSION PLAN

Being a trust is just like having a mortgage sitting on your house. The first thought every month is how you are going to make your mortgage payment.

MICHAEL HEIER

TRINIDAD ENERGY SERVICES INCOME TRUST

Becoming a trust doesn't actually handcuff management. All it does is force them to go back to the institutions and the . . . retail market and have them bless the transaction.

PHIL BROWN

TORYS LLP

There are no texts you can read that say: 'Here's how you grow through an income trust, follow this formula and this step-by-step approach.'

KEITH CARRIGAN

BFI CANADA INCOME FUND

Conversion liftoff

Income trust conversions, virtually a novelty five years ago, have ballooned to almost $65-billion in value in 2006, as an increasing number of large-capitalization companies are drawn by the promise of these tax-efficient structures. In the process, investors are getting their hands on a bigger chunk of Corporate Canada's cash flow than ever before.

Who's next?

The mammoth income trust conversions of BCE Inc. and Telus Corp. have conferred further legitimacy on this financial structure, and paved the way for other large-capitalization companies to follow suit -- some of which are from industries not historically deemed suitable for the trust model. In a research note this week, Merrill Lynch & Co. analyst Joel Sutherland described the BCE announcement as a "milestone," and predicted that every mature company is now "fair game" for a conversion. Here are his thoughts on where the next raft of trust conversions will occur:

The very likely

Media. This is a potential hot spot for the trust market. If more media mergers follow Bell Globemedia's purchase of CHUM Ltd. this summer, Mr. Sutherland expects most media assets will consider pursuing a trust next year, either through a conversion or spinoff.

Industrial products, merchandising and retail are each considered "prime candidates" for the structure.

The possible

Technology and biotech companies have not always been considered as ideal trusts, in part because they are volatile, in part because they can have high capital expenditures, and in part because they tend to make strategic acquisitions that are not accretive for some time. Yet Mr. Sutherland believes some of these companies may consider the trust model if they are paying cash taxes.

The very unlikely

Banks are not considered likely candidates because they are heavily regulated and generate huge tax revenue for Ottawa -- about 15 per cent of all corporate taxes in the country.

Pulp and paper companies are also unlikely, according to Merrill Lynch, given recently generated tax losses.