When Toronto-based Faircourt Asset Management Inc. first started plugging “split shares” based on income trusts to advisors in 2003, Mark Bohnhardt saw an opportunity for his clients and signed on for Faircourt Income Split Trust, which raised $45 million in its initial offering.

Bohnhardt, a senior advisor at BMO Nesbitt Burns Inc. in Oakville, Ont., was attracted by the 7.5% yield the split trust paid on the preferred securities portion of the investment and the 10% yield being offered to holders of the capital units.

Split shares based on income trusts are the latest wrinkle in the split-share marketplace, and so far Bohnhardt’s clients “have been pleasantly surprised” with their performance, he says.

Janis Koyanagi, senior manager, business development, at the Toronto Stock Exchange predicts that split-share trusts will be a growth area going forward. “I think they’re the next generation,” she says. “It’s the cheaper way to buy yield.”

In addition to Faircourt, a number of firms, including Mulvihill Capital Management Inc., Sentry Select Capital Corp., Quadravest Capital Management Inc. , Scotia Capital Inc. and Barclays Global Investors Canada Ltd. , all based in Toronto, have brought split-share trusts to the market.

And more are expected. At press time, First Asset Investment Management Inc. was raising funds for Split REIT Opportunity Trust. Its mandate is to invest in a basket of real estate income trusts that provide stable monthly distributions but also have the potential to grow from the expected consolidation and privatization that the manager foresees will take place in the REIT market. The trust expects to pay preferred securityholders a 5.75% yield and the return of their capital, and unitholders a targeted 5.75% yield.

The new versions of these split-share products are structured differently from original issues because of the nature of the underlying income trust investments. With the new version, two distinct investment opportunities are produced by creating a closed-end fund based on a basket of income trusts and “splitting” the cash flow from those investments.

The original type of split shares — issued about 20 years ago — was held by closed-end funds and based on individual stocks. These were known as split-share corporations, because the investment was set up in a separate company.

A split-share corporation comprises two share classes — a preferred share, which pays a fixed dividend; and a capital share, which may or may not pay a dividend but which entitles the holder to participate in the capital gains. Both shares trade on the TSX under their own symbols.

Preferred shareholders rank higher than capital shareholders, so they are entitled to be paid first from any proceeds that the investments generate. They are also entitled to get their initial investments back when the fund wraps up, which is usually after five years. However, the underlying investments could always tank, so there is no guarantee that their capital can be repaid.

The capital shareholders are entitled to the investment’s growth and usually any excess in dividends above the amount required to pay the obligations to the preferred shareholders.

That works well when the fund invests in corporations such as banks, utilities and energy companies. However, as more companies adopt the income trust structure to reduce their tax burdens and throw off their lucrative income stream to investors, says Joel Binder, a corporate lawyer at Stikeman Elliott LLP: “People started thinking about how to split an income trust. You can’t have them held by a corporation.”

That’s because such a move has negative tax consequences, as a trust must pay out most of its cash flow. “The math just doesn’t work,” he adds. “It could produce an awful result.”

But lawyers have found a way around the tax hurdle. Instead of using a corporation to create the closed-end investment, these new split-share products use a trust structure. That protects the tax treatment of payments generated by the basket of income trusts and allows them to be flowed to the investors in the trust on a tax-efficient basis.

Because of the trust structure, there are no shareholders. Instead of preferred shares, a split-share trust resorts to conventional debt and issues preferred notes that pay a specific interest rate. These are preferred securities and trade on the TSX. The units — the second part of the split-share investment — also trade on the TSX, and they are entitled to the gains generated by the basket of income trusts. The trust usually has a life of five years.

@page_break@Preferred securityholders essentially hold mortgages that entitle them to be paid first. They rank above the unitholders, but below the monies the trust owes under any loan facility and to the fund managers.

As well, the preferred securities are rated by a bond agency, usually as Pfd-2; and under the trust agreement, holders are entitled to receive their initial investment back at the end of the trust’s life. (However, these notes are not principle-protected; as with earlier split shares, there’s no guarantee that there will be enough value in the trust at the end of its life to repay the capital amounts invested by the preferred securityholders.)

Unitholders are usually paid regular distributions, which under a trust structure amounts to a return of capital for tax purposes. They are then entitled to any additional gains in the fund’s assets and any excess distributions, once the preferred payment obligations are met. If the investments do well, the unitholders do well. If the investments tank, unitholders feel the pain because the preferred securityholders rank above them when the assets are divvied at the end of the trusts’ life.

“The trust units get a combination of monthly distributions that is tax-efficient,” Faircourt president Charles Taerk says, which are a mixture of dividends and return of capital. The preferred securityholders get their set yield and the capital unitholders share in the growth. He says trusts are a “much better vehicle to do a split on” than corporations because of the tax treatment.

As well, the managed aspect means that someone is watching the investments and dumping underperformers, compared with a passive, buy-and-hold strategy.

Taerk notes that energy is a “volatile sector. Our job as managers is to make sure we maintain diversification.”

One important feature of a split-share offering is built-in leverage.

“Basically, what it does is provide a leveraged instrument to an investor who is seeking capital appreciation, and at the same time it provides a different class of investors with usually a Pfd-2-rated note,” says Binder.

Take the example of a $100-million split-share trust paying a 5.75% yield to preferred securityholders. Half the amount raised comes from preferred securityholders and half from the unitholders. The full amount is then invested.

Brian McChesney, managing director at Scotia Capital, one of the companies involved prominently in the split-share market, explains that capital unitholders are essentially borrowing $50 million from the preferred securityholders at an attractive rate of 5.75% to invest in the businesses that make up the portfolio. That, combined with their own $50 million investment, means dollar leverage of 2:1.

As well, the preferred securityholders, who are entitled to both interest payments and their return of capital, have almost 2:1 coverage to protect their capital. Most split-share trusts carry a loan facility allowing them to borrow up to 10% of the amount in the fund, which is usually used to run the trust but can also be used to provide a little more oomph in the portfolio.

John Simpson, president of Mulvihill Capital, says what he likes is: “You can offer two different types of products to the same client.”

The preferred securities can be put in a registered account to shelter the payments from taxes, while the units can be held outside the RRSP, where they are treated as return of capital and can take advantage of the capital gains and losses rules. “That it makes the product more stable,” he says.

Bohnhardt adds that he sees the preferred security as a “GIC alternative for people looking for steady payments.” IE