(The following story by Boyd Erman appeared on the Globe and Mail website on July 20. With files from reporter Sinclair Stewart in New York.)
TORONTO — Brookfield Asset Management Inc.’s buyout plan for Canadian Pacific Railway Ltd., which is based on the idea of splitting the company into one arm that runs trains and another that owns the lines, may be tough to stickhandle past safety regulators and tax authorities, analysts and investment bankers said.
According to sources, Brookfield wants to divide CPR into an infrastructure company that would own the real estate under the tracks and could support high levels of debt, and an operating company that would own and run the trains. The lines, which Scotia Capital estimates may be worth $7-billion, could be leased to the operating company, which could then shelter some income because lease payments are tax deductible.
A pension fund such as the Caisse de dépôt et placement du Québec, which sources said partnered with Brookfield in the original approach to CPR, could take a stake in the real estate arm and use its tax-free status to help the buyout group to pay a higher price.
“It’s a complicated business, but do-able,” said one investment banker who has looked at doing a similar transaction with CPR. The idea is to turn the underlying real estate into “essentially a series of toll booths” that would collect fees from the train operator.
With infrastructure assets such as toll highways in fashion, the track system might rate a higher value.
Sources said that in the wake of Brookfield’s approach, other big pension funds and private equity firms have ratcheted up their analyses of CPR and are weighing whether to form competing consortiums.
But the complexity of the potential transaction had analysts from firms such as TD Securities and RBC Dominion Securities advising investors to take profits in case a bid doesn’t materialize. As a result, CPR’s stock took a breather yesterday. After jumping almost 16 per cent on Wednesday when news broke of the takeover approach led by Brookfield, CPR’s shares fell 29 cents to $88.71 yesterday on the Toronto Stock Exchange.
Analysts said any potential auction would top out around $100, because returns from the transaction are already relatively low at current prices. Scotia Capital yesterday estimated that CPR could produce a 12-per-cent rate of return for a buyer who paid $92.
Such returns are too scant to be attractive to all private equity players, which often seek returns of better than 20 per cent a year, and would likely only appeal to infrastructure-focused groups, of which there are only a handful.
“It only works if you say it’s not a typical private equity play,” said another investment banker who has looked at the numbers. “It only makes sense if you say it’s an infrastructure rate of return.”
Any transaction would have to be carefully structured to ensure it doesn’t run afoul of the Canada Revenue Agency, which would halt any deal structured too obviously to avoid tax, bankers said.
Tax issues may have been the stumbling block when CPR rebuffed Brookfield earlier this year, analyst James David of Scotia Capital said in a report yesterday.
Since whatever was discussed was “likely conditional on due diligence concerning the potential tax implications of any infrastructure sales, [CPR’s] board may not have been motivated to open the books,” Mr. David said.
Analysts also pointed to potential regulatory risks.
“There’s no law that says you can’t do it,” UBS’s railway analysts wrote of splitting CPR in two. “However, breaking up a railroad presents substantial challenges.”
A breakup would likely trigger hearings by railway regulators in Canada and the United States, which have their main focus on safety. The consequences of the separation of rail operator and track owner in Britain during the 1990s could sour overseers on the idea.
Britain privatized its rail system, creating a company called Railtrack PLC that owned much of the track and infrastructure in the country while other companies would run the trains. However, after about 10 years the experiment proved a failure, with a fatal crash linked to maintenance shortfalls raising public ire and the company ending up in receivership.
“As part of the public hearing process, safety advocates and unions would attempt to block it [a split-up of CPR], given the infrastructure company would maximize earnings by spending as little as possible on maintaining the track, adding to the potential for accidents,” the UBS analysts wrote, citing the British experience.
Under federal regulations, the Transport Minister can ask for a review of any acquisition of a railway, said Marc Comeau, a spokesman for the Canadian Transportation Agency, which licenses railways.
“It’s relatively rare, but there is always that option if the minister wants to look at a transaction,” Mr. Comeau said.