Ignoring warning signs will be painful

Questionable trusts can be identified by a number of factors, not the least of which is usually a large gap between pre-tax profits and distributable cash.

Understated maintenance capex and working capital needs ( which are risks to longer-term stability) will result in a larger disparity between cash available for distribution and pre-tax income. Other issues to be leery of include high payout ratios, operating company volatility, and small retained interests, short lock- up periods, and a lack of subordination for company founders.

I have warned about trusts in several columns this year, paying special attention to the myths surrounding cash yields, and the lack of comparability of distributable cash figures and payout ratios. What makes investors particularly vulnerable is that no useful action is being taken by regulators to diminish the bubble that has formed with respect to income trust values.

Quite often, trust valuation premiums cannot be explained by mere tax savings. Indeed, the current debate surrounding the tax status of trusts is trivial compared to the overall business and financial risks inherent in many trusts. Thus, aside from general market hype, the inflated values seem to result from a lack of policing of distributable cash and payout ratio calculations. Confusion reigns when investors are told to ignore the bottom line and focus on the performance measure that management has created. It feels like we’ve stepped back in time by five years.

Too much of the information on trusts available to investors is being provided by marketers and other parties who make money based on the amount of deals done, not their performance in the market afterwards. Thus, investors need to do a lot of their own work in determining the quality of individual trusts. Ignoring the warning signs will quickly result in lost savings once the market starts to assess trusts with a more discerning eye.