The Canadian market for initial public offerings has always been a flighty business. In recent years, however, the market has been buoyed by the presence of relentlessly hot income trusts. But with that pillar of support now removed, the market seems likely to revert to its fickle ways.

Ottawa’s surprise move this past October to take steps to change the way income trusts are taxed caused immediate fallout. Data from Price-waterhouseCoopers LLP Canada show the decision effectively brought the Canadian IPO market to a halt in the fourth quarter — and the outlook for 2007 remains resolutely grim.

PwC reports just five new IPOs were offered on the Toronto Stock Exchange in the fourth quarter of 2006, raising a combined $987 million, compared with 19 deals totalling $1.5 billion during the same period in 2005.

Income trusts have made up at least half the IPO market in the past few years, so passage of the proposed tax plan could mean the total value of IPO issuance in 2007 will drop by 50%, says Ross Sinclair, PwC’s national leader of IPO and income trust services in Toronto. “You’re going to see a very dismal first quarter of 2007,” he says, noting there have been no income trust IPOs and fewer than usual traditional corporate deals.

PwC measures the IPO market solely in terms of new companies raising capital; it does not include the other vehicles that Investment Executive counts in its research. (IE includes everything that the TSX considers an IPO on the TSX and TSX Venture exchanges, including trusts, income funds, split shares and other vehicles beyond the traditional common stock IPO.) By PwC’s measure, IPO issuance has been in the $6 billion-$7 billion range in the past few years. This year, Sinclair expects to see total issuance in the area of $3 billion-$4 billion.

Sherry Hum, financial analyst, capital markets, at the Investment Industry Association of Canada in Toronto, expects that the traditional IPO market should hold its ground this year. “Looking ahead, common-equity IPO issues will probably hold close to recent activity. Despite some growing headwinds in the market, there is enough momentum in the system to sustain current levels,” she says. “In a nutshell, Canada’s red-hot M&A market, trust slowdown, solid global demand and firm resources prices should continue to provide support for common issuance ahead.”

Yet the ongoing uncertainty surrounding implementation of the income trust tax proposal looms over the market for the foreseeable future. As long as the government remains a minority and advocates a policy that faces considerable public and political opposition, the ultimate tax situation for trusts remains in doubt. It’s possible the Harper government could fall on the issue, or some other, before the legislation is passed.

Alternatively, the trust tax plan could be modified or abandoned. Until such uncertainty is resolved, potential IPO issuers may simply put their plans on hold.

Looking further ahead, if the tax plan is killed, the market would probably revert to its old ways. Income trusts would still account for about half the overall IPO market and continue to provide a steady supply of lucrative underwriting business. Trusts have seemingly enjoyed a far wider IPO window than conventional equity underwritings because the demand for yield-producing securities seems insatiable.

Similarly, the market would respond accordingly if the tax policy is modified, as has been suggested by the House of Commons committee that held public hearings on the issue, by reducing the proposed tax or extending the transition period.

A reduced tax would probably preserve some of the advantages for firms structuring themselves as income trusts, so the trust IPO could be expected to re-emerge to some extent. A longer transition period probably wouldn’t do much, on its own, to revive trust IPOs, assuming new trusts are subject to the full tax straight away.

If the tax policy is implemented as originally conceived, the income trust IPO market would effectively be dead — the proposed tax completely erases the chief advantage of structuring a company as an income trust. In this scenario, the market’s response would probably be a combination of restoration and innovation — with some firms reverting to traditional equity issues and others trying to dream up novel ways of tapping into the demand for high-yielding securities.

@page_break@While some companies may hold out hope that the tax proposal will be killed, the most likely scenario is that it will be passed, and companies will have to come to terms with their funding needs. One option is to revert to doing common-share deals.

Hum predicts the equity IPO market will benefit this year from the turmoil in the trust sector. She notes that trust financings “tanked” to a four-year low in 2006, and common-equity issuance was a beneficiary: “We already witnessed a notable pickup in common-equity issuance last year.”

Such financings were up 16% in 2006, she says, and common-equity IPOs accounted for more than 57% of the total equity issuance market in 2006, up from a 45% share in 2005.

Still, it is unlikely that all the companies that would have done income trust issues will instead do common-stock deals. Interest rates are still relatively low, so many firms may decide to borrow rather than issue equity. Others may look to create innovative securities that recreate some of the magic of the income trusts’ glory days, such as high-dividend hybrid equity instruments that may appeal to the same investors who so eagerly bought income trusts.

Sinclair expects to see companies and their investment bankers dreaming up new types of high-payout securities to fulfil the demand the income trusts tapped. He notes, however, that it will take time for such products to be developed; no one is likely to devote the resources required to do it until there is clarity about the new tax rules.

“It’s hard to develop a new product when you don’t even know what all the rules are,” he says.

But, he cautions, the new products that may emerge to meet investor demand for yield may not be ones that also work to take a new company public.

In the interim, private-equity players may benefit from the uncertainty. The pause in the IPO market essentially removes private equity’s chief competition for deals, Sinclair notes. If there isn’t a possible IPO driving up valuations, buyouts will become more affordable for private-equity firms awash in capital and eager to invest it.

Data from Canada’s Venture Capital and Private Equity Associa-tion and Thomson Financial show the total value of disclosed investments in Canadian companies made by buyout funds more than doubled to US$10.9 billion in 2006 from US$4.5 billion in 2005. New fundraising by Canadian buyout funds also reached record levels, with $6.4 billion in new capital raised in 2006, vs $1.4 billion in 2005.

Big dollars are floating around, looking for a home. And with the IPO market in turmoil, many en-trepreneurs may end up taking the private-equity route to raise capital or diversify their holdings. Several years down the road, such deals could be queuing up in the IPO pipeline. For now, however, legislative uncertainty will probably keep many firms away from the public markets. IE