Income trusts and their kind have taken over the Canadian market for initial public offerings but, while feeding the hunger for yield remains the dominant driver of IPO action, the market for traditional IPOs is reviving, as well.

The IPO market was remarkably robust in 2004, with a heavy volume of deals bringing billions in new equity to market. Investment Executive research indicates that there were 115 IPOs on the Toronto Stock Exchange in 2004 that raised $17.6 billion. The bulk of those offerings, however, came from income-producing vehicles — income trusts, income funds, income-participating securities, income-deposit securities and split shares. (The TSX classifies all such securities as IPOs in its monthly statistics, and IE adopts its definition for the purposes of our research.)

The dominance of income-focused vehicles is nothing new for the Canadian IPO market.
Indeed, if it weren’t for income-focused deals, the underwriting market would have died between 2001 and 2003, says Jon Cockerline, director of capital markets at the Investment Dealers Association of Canada in Toronto.

What was new in 2004 and continues into this year is the return of the traditional IPO, he says. It’s not that the income-focused deals aren’t booming — income trusts still represent the bulk of deals on the TSX and the lion’s share of the value of new equity — but traditional IPOs now have a pulse, after all but disappearing in the past few years.

The revival is important, not simply as an indicator of economic health and investor confidence but also because it feeds back up the financing food chain. Cockerline says the option of doing an IPO presents venture capitalists and private equity investors with an exit strategy and, therefore, an incentive to fund early-stage companies.

Companies go public for other reasons, too;
for example, to create acquisition currency, raise capital or fund growth. Indeed, a recent working paper published by the Cambridge, Mass.-based National Bureau of Economic Research finds that raising capital is the primary reason for IPOs.

The paper, by Michael Weisbach, chair in finance at the University of Illinois at Urbana-Champaign and a research associate of the NBER, and a doctoral student at the same school, Woojin Kim, sampled almost 17,000 IPOs in 38 countries from 1990 to 2003. Their research assessed the differences between firms that go public by selling new shares from treasury, and those that go public by a secondary offering of insiders’ shares.

Weisbach and Kim found that about 79% of IPOs are sales of new treasury shares and, following an IPO, the firms invest more in their businesses (capital spending, R&D investment and debt repayment) than firms that go public via a secondary offering. They concluded that raising capital is a key factor in the decision to go public and, because that can lead to greater business investment, it’s a good thing for the economy in general.

In Canada, the rise of income trusts may be making the push to go public even more compelling. Because of their tax-efficient structure, income trusts enjoy a lower cost of capital than traditional firms. As they proliferate, the chore of competing with them may add to the pressure to adopt the trust structure or even to raise capital the old-fashioned way.

In a recent research report, First Associates Investments Inc. analyst Barbara Gray says the ability of income trusts to exploit their tax advantage “to make accretive acquisitions has created a unique arbitrage situation.”
However, the report cautions: “There is the potential risk for business trusts to start overpaying for assets, reflecting the easy access to capital and the fact that the cost of that capital continues to fall.”

So, despite persistent predictions that the income trust bubble must soon pop, there’s every indication it has room to run. The federal government has so far declined to deal with the tax arbitrage opportunity that has made the structures so attractive to issuers and investors alike. Provincial governments are resolving liability concerns.
The S&P/TSX Canadian index policy committee is adding these securities to the index later this year, adding further legitimacy.

More important, interest rates remain low, which is key, as new issue activity in the income trust sector is proving very interest-rate sensitive. Cockerline says trust IPOs dried up in the third quarter of 2004, when it appeared that the Bank of Canada would hike rates imminently and substantially. But the strong dollar and diminishing economic expectations helped dissipate some of the rate hike worries, and trust issuance came roaring back in the fourth quarter.