Get set for more trust collapses

Heating Oil Partners flameout should be a lessson

Another

investor wake-up call

is just around the corner.

Traditional economic theory offers the myth of market efficiency by assuming that large numbers of buyers and sellers fiercely interact to set fair market prices. The trouble with that theory is it doesn’t do much to explain flameouts such as Heating Oil Partners Income Fund, which recently filed for bankruptcy, or many of the other precarious trust valuations in the market today.

Heating Oil Partners units (HIF/TSX) are now worthless after their delisting last week, an incredible decline from the $10.40 price on the new offering of units in July, 2004.

While roughly $220-million in individual savings have evaporated, the much more troubling issue is that investors are ignoring the collapse, and passing up the opportunity to learn anything from the first income trust postmortem.

The apathy can surely be traced to the furious pace at which trusts have come to market over the past few years. What is troubling is that as the pace slows, as it has recently, the failures will become more frequent and have a greater net impact. The relatively nascent nature of the business trust market will only magnify the problem.

Some trusts collapse right out of the gate, like Arriscraft International Income Fund, which fell by 60% in the eight months after its IPO last December. But more often, as with HIF, the market gives new trusts a generous grace period.

Savvy investors have been using these prolonged warnings as an opportunity to exit questionable trusts before their eventual collapse. Unfortunately, it is mostly retail investors who are left holding the bag in the end.

I first mentioned the mortal problems of HIF in my April column, when there was still $4.80 left in the unit price. As well, difficulties were evident in the trust long before that, as I mentioned at the time. HIF reported net losses in the three years before it became a trust in early 2002.

It subsequently reported three more years of losses as a trust. The gap between cash available for distribution and actual distributions had to be funded with working capital (a clearly unsustainable situation).

HIF attempted to extend its grace period by completing six separate acquisitions during its first two years as a public company. While the largest and final acquisition allowed the company to squeak through a second offering of units, it didn’t buy as much time as management had hoped. The slow march to bankruptcy started shortly thereafter.

How this ties into the current problem facing the market is that many more trusts are also reaching their second anniversary. The two-year mark is rather arbitrary, and could be more or less depending on the individual trust. The point is that at no time prior has there been as many trusts reaching maturity, when their longer-term stability will be scrutinized, and they are less likely to be judged on mere promise.

Other warning signs of a peak in the trust market include the increasing number of ill- suited companies contemplating conversion, and the proliferation of companies becoming trusts once they have reached the height of their economic cycle. Thus, now is the time to exit those trusts whose sole purpose has been to feed the underwriters over the past few years.