There are certain financing options that differ from traditional stocks and bonds, royalties and income trusts among them. This article examines these trusts to determine their uses and value.
What are Royalties?
Royalty and income trusts are special purpose financing vehicles created to make investments in operating companies or their cash flows. Investors supply capital to a trust, a legal entity that 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 in the form of royalties.
Characteristics of Royalties and Income Trusts
Royalties and income trusts are neither stocks nor bonds, although they share some of their characteristics. Investment trusts are created to hold interests in operating assets that produce income and cash flows, then pass these through to investors. A “trust” is a legal instrument that exists to hold assets for others. A “trust” investment that 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.
Cashflow Royalty Created!
For example, let’s say that we own an oil company, CashCow Inc., which has many mature oil wells producing a steady product. The prospect for these wells is fairly mundane. With well-known rates of production and reserves, there 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 amount of time. At the (hypothetical) 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 royalties 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 wouldn’t we just 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 “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.
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 that will be taxed in the hands of the investors. We can offer a 10% yield to the trust unit-holders, 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 is very high compared to the price it was a few years ago. That is why the prospectus for these trust deals talks about ‘forecasted’ revenues and earnings.
Why were Income Trusts so Popular and What Happened on October 31, 2006?
Income trusts were attractive to investors because they promised high yields compared to traditional stocks and bonds. By eliminating corporate level tax, they provided significant tax benefits to investors from 2001 to until October 2006 when the Department of Finance imposed a corporate level tax on publicly-traded income trusts. Income trusts would be taxed at a rate comparable to corporate tax rates and investors/unit-holders would also be taxed on income trust distributions similar to shareholders of a corporation. This tax law change was designed to stop tax leakage from businesses adopting a flow through trust structure, which the tax loss was estimated at $700 million annually.