Royalty and Income Trusts are special purpose financing
vehicles which are created to make investments in operating companies or their
cashflows. Investors supply capital to a trust, a legal entity which exists to
hold assets, by purchasing "trust units". The trust then uses these
funds to purchase an interest in the operating company. The trust then
distributes all its income to holders of the trust units.
Income and Royalty trusts are neither stocks nor bonds, although they share
some of their characteristics. Investment trusts are created to hold interests
in operating assets which produce income and cashflows, then pass these through
to investors. A "trust" is a legal instrument which exists to hold
assets for others. A "trust" investment which uses a trust (the legal
entity) to hold ownership of an asset and pass through income to investors is
called a "securitization" or an "asset-backed security".
The trust can purchase common shares, preferred shares or debt securities of
an operating company. Royalty trusts purchase the right to royalties on the
production and sales of a natural resource company. Real estate investment
trusts purchase real estate properties and pass the rental incomes through to
investors.
Royalty and Income Trusts are attractive to investors because they promise
high yields compared to traditional stocks and bonds. They are attractive to
companies wishing to sell cashflow producing assets because they provide a much
higher sale price, or proceeds, than would be possible with conventional
financings. The investment characteristics of both types of trusts flow from
their structure. To understand the risks and returns inherent in these
investments we must go beyond their promised yield and examine their purpose and
structure.
Cashflow Royalty Created!
For example, let's say that we own an oil company,CashCow Inc., that
has many mature producing oil wells. The prospect for these wells is fairly
mundane. With well known rates of production and reserves, ther is not much
chance to enhance production or lower costs. We know that we will produce and
sell 1,000,000 barrels per year at the prevailing oil price until it runs out in
a forecasted 20 years. At the current price of $25 per barrel, we will make
$25,000,000 per year until the wells run dry in 2017.
We're getting a bit tired of the oil business. We want to sell. Our
investment bank, Sharp & Shooter, suggest that we utilize a royalty
trust. They explain the concept to us. CashCow Inc., our company, sells
all the oil wells to a "trust", the CashCow Royalty Fund. The
trust will then pay CashCow Inc a management fee to manage and maintain
the wells. The CashCow Royalty Fund then gets all the earnings from the
wells and distributes these to the trust unit holders. We ask, "Why we
just wouldn't sell shares in our company to the public". Sharp &
Shooter tells us that we will get more money by setting up the trust since
investors are "starved for yield". We agree.
Sharp & Shooter then do the legals and proceed with an issue.
They offer a cash yield of 10%, based on their projections for oil prices, the
cost structure, and management fee to CashCow Inc. This means they hope
to raise $250,000,000. We're rich!!!!!!!!!!!
Yield to the Poor Tired Investment Masses
What about the poor tired investment masses? Starving for yield in the low
interest rate revolution, the CashCow Royalty Fund lets them have their
investment cake and eat it too. Thanks to the royalty courtiers of Sharp &
Shooter, yield starved investors can buy a piece of a "high yield"
investment. Sounds a bit strange, but the royalty trust turns the steady income
that made the operating company CashCow Inc. financially mundane and
boring into a scintillating geyser of high yield.
Since the operating company, CashCow Inc., no longer has to explore
for oil or develop technologies to increase production, its expenditures will be
much lower under the royalty trust structure. Remember, the purposes of the
trust is to pay out the earnings from the oil sales until the oil fields are
exhausted. No more analysts and shareholders complaining about "depleting"
resources. Paying out the steadily depleting oil sales are now the idea. This
means that none of the revenues and profits from production have to be expended
on securing new supplies. The continuing operations of CashCow Inc. can be
downsized now that maintenance is the only need. No more exploration department,
huge head office staff, or worldwide travel bills.
The investor, who might shun a low dividend yield of 3% on an oil stock or
worry about the risk of a lower grade corporate bond, sees the bright lights of
high yield beckoning. Our $25,000,000 in revenues is only reduced by a
management contract of $1,000,000 paid to the now shrunken CashCow Inc. to keep the fields maintained. All the earnings will be passed through to the CashCow Royalty Trust which will be taxed in the hands of the investors.
We can offer a 10% yield to the trust unitholders which means that we can raise
$250,000,000.
What's Wrong with this Investment Picture?
One of the first questions to ask about an investment is, "What's in it
for them?". Why would the owners of CashCow Inc. part with their
$25,000,000 in income? Not just to provide a higher yield for the yield starved
investment masses. Logically, the owners of an operating company would only sell
their interest if they could use the money to more effect somewhere else. Think
about it for a minute. If the owner of CashCow Inc. can take
$250,000,000 and put it into another investment with a higher yield, it should
be done. The fixed return of 10% on established, tired wells might be a tad low
next to the upside on a new oil field, or a well diversified portfolio of growth
stocks.
Another question to ask is,"Why didn't the owner just sell the company
to another oil company?". The simple answer is that they get more money by
selling to the income trust. Which begs the question, "Why is the price so
high?". Other companies realize that the price of oil goes up and down and
that the price of $25 a barrel today is very high compared to the $10 it was a
few years ago. At $10 per barrel, the cashflow would only be $10,000,000 a year.
That is why the prospectus for these trust deals talks about 'forecasted'
revenues and earnings. The other oil companies also realize that 'proven
reserves' has an element of guesswork, and that there might be less oil in the
ground, or it may be 'more difficult to recover' than expected.
All this means that the 10% "yield" is not fixed in stone, as we
now realize. As with all investments, we must take our time and do our analysis.
As Uncle Pipeline says, "It's all in the cashflows!" |