SPECIAL REPORT

CRACKED FOUNDATIONS

TREMORS ROCK THE HOUSE THAT JACK BUILT

JOHN DALY November 23 1992
SPECIAL REPORT

CRACKED FOUNDATIONS

TREMORS ROCK THE HOUSE THAT JACK BUILT

JOHN DALY November 23 1992

CRACKED FOUNDATIONS

TREMORS ROCK THE HOUSE THAT JACK BUILT

SPECIAL REPORT

The close-knit circle of executives who built a corporate empire for Peter and Edward Bronfman have heard the complaints before—but now they appear to be more puzzled by them than ever. For years, investment analysts and other critics of the Edper group of more than 100 companies have described it as an overly complex “pyramid,” “maze” or even “house of cards.” During the 1970s and 1980s, senior Edper executives turned aside those charges by pointing to growth in share prices and healthy profits. But for the past two years, the foundations of the empire—the resource, financial services and real estate companies— have been battered by the recession. Thousands of Canadians who own shares in those firms have suffered from a drop in their stock prices.

Senior Edper executives, who are required to borrow heavily to buy company stock under the company’s compensation system, are being squeezed as well, as the company struggles to fulfil financial commitments. Now, many analysts say that Edper may have to sell off large chunks of the empire to preserve many of its core companies. Said Brian Neysmith, president of the Montreal-based Canadian Bond Rating Service: “A company cannot keep paying out money that it is not earning.”

The complex structure and the requirement that senior Edper executives tie their own fortunes to their employer are the two central tenets that have guided the empire for more than two decades. Both were established by Jack Cockwell, the brilliant but publicity-shy South African-born accountant and strategist for the Bronfmans who holds senior positions in several Edper companies. During the 1970s and 1980s, the empire prospered.

But since Canada plunged into a recession two years ago, some analysts claim that the unique corporate structure has exacerbated Edper’s difficulties. Even Edper executives now acknowledge that there are some problems with the old blueprint. Said Robert Harding, the chief operating officer of Hees International Bancorp Inc., one of the leading Edper companies: “We are all committed to simplifying the structure and it has become

one of the cornerstones of our long-term business plan.”

Cockwell designed the pyramid to give Edper maximum leverage by allowing the group to gain control of large companies for a minimal investment of its own funds through so-called top-down or cascade financing. According to a simplified scenario often cited by analysts and Edper representatives, Edper can use the method to gain control of $1.2 billion in assets with just a $50 million initial investment

Dec.31 1989 Dec.31 1990 Dec.31 1991 Nov.13 1992 Bramalea $21.50 $6.12 $5.25 $0.45 29.75 16.62 14.87 9.37 17.87 9.50 8.00 2.98 24.25 13.62 10.25 2.20 20.62 12.37 10.75 3.70 24.25 16.75 18.62 17.50 A BUMP! RIDE Hees International Royal Trustco Trizec Trilon Financial Noranda

of its own money. The process starts with Hees, the senior financing company in the Edper group, issuing $100 million in new stock. Edper itself would then buy half the shares through a related company, and Hees would sell the other half to the public. Hees would then take the $100 million it received from the stock sale and invest it in a $200-million share issue by another Edper company, like Brascan Ltd. Again, the group would sell half the issue, $100 million, to the public. By repeating the process three more times, Edper would end up with 50 per cent control of $1.2 billion in assets.

Investment: During the boom years of the 1980s, Cockwell’s method succeeded effortlessly. The Edper group raised close to $30 billion in equity from the public and from its own earnings and used it to help gain control of some of the largest corporations in Canada. All the while, Edper’s own investment in its operating companies never exceeds 50 per cent—a Cockwell rule. In fact, in most cases, it is much less than that. According to the 1991 annual report of Edper Enterprises Ltd., a holding company near

the top of the structure, the company’s socalled effective equity interest in John Labatt Ltd.—after tracing it through several holding companies—is only 13 per cent. For mining and forestry giant Noranda Inc., that interest is just 18 per cent.

Under the equally elaborate executive compensation system designed by Cockwell, senior Edper managers were among the principal beneficiaries of that growth. Edper pays its top executives low salaries by Bay Street standards—just over $100,000 a year in many cases. But it also requires those executives to take out loans to buy stock in their companies. In the case of the 15 partners in Hees who direct much of the Edper group’s overall strategy, the average value of loans outstanding to them was just over $1 million at the end of 1991.

Edper sets the interest rates on the loans to match the dividend rate on the shares. The goal, according to Harding, is “to align the executives’ interests with those of the shareholders.”

And during the 1980s, the value of the stock supporting the loans climbed steadily, making it desirable for such loans to be extended.

In addition to enhancing Edper’s ability to expand, Cockwell designed the structure to achieve what he calls tax efficiency—in other words, to take maximum advantage of corporate tax laws. During the 1980s, Edper companies, on average, paid out much less of their income in tax than other large Canadian corporations.

Uneasy: But even before Canada plunged into a severe recession,

Edper’s elaborate cross-ownership arrangements and Cockwell’s constant shuffling of its holdings and earnings made many pension fund managers and other institutional investors uneasy. While small investors were clearly dazzled by the strong performance of the Hees holding companies during the 1980s, institutions have long been wary of investing in anything but the public operating companies at the bottom of the structure, firms like Labatt or Noranda. Leonard Racioppo, a partner in Canada’s largest pension fund management firm, Montreal-based Jarislowsky Fraser & Co., said: “All those companies are paper companies. No one is really sure of what is there.”

Racioppo and other analysts say that other features of Edper’s structure also concern them. For one thing, as earnings flow through the overall structure, they are combined and reported in several companies’ financial statements. Moreover, in addition to the 32 public companies in the Edper empire, money often passes though some of the hundreds of private companies in the group, which are legally entitled to keep their finances confidential.

Edper executives, however, say that they have tried to include much more detail in their

financial statements in recent years. As well, they say that they are meeting more regularly with analysts, clients and reporters to explain their strategies and way of doing business. Added Harding: “We believe that we have made some progress with each of these constituents and are prepared to do a lot more work in this area.”

The economic slowdown that began in 1990

PUICING TOGITNIR THI PUZZLI

Edward

Bronfman

Family

Peter

Bronfman

Family

Edper

Group

Managers

Pagurian

Edper

Holdings

Edper

Enterprises

Hees

Holdings

Brascan

Holdings

Hees I Carena International ■ Holdings

Brascan

Carena

Developments

John I Trilon Labatt «Financial

Consolidated

Carma

Corp.

Noranda

Royal

Trustco

London

Life

Coscan

Development

has clearly put Edper under a great deal of pressure. The real estate, resource and financial service sectors all slumped almost simultaneously, driving down the profits and the share prices of many of the companies at the bottom of the pyramid. Common shares in developer Trizec Corp., for one, closed last week at $2.20, down from $24.25 at the end of 1989. Noranda’s common shares have declined to $17.50 from $24.25 over the same period. Royal Trustco common shares closed at $2.98, compared to $17.87 three years ago.

The design of the Edper structure has intensified the pressure caused by the recession—at the top levels as well as the bottom. Just as

financing is designed to flow down in the Edper empire, earnings, in the form of dividends, should flow back up to the top. But unlike equity, which multiplies as it moves down the ladder, dividend income shrinks as it moves up, because Edper pays dividends to outside shareholders as well as to its own holding companies.

For small investors, those steady and substantial dividends have been one of the main attractions of stock in the Edper companies. Under the principles laid down by Cockwell, those dividends are a necessary cost of doing business, like interest on loans. As a result, Edper managers have been extremely reluctant to reduce dividends, even when the group’s earnings began to suffer during the recession. Those managers also have a direct personal interest in maintaining those dividends and share prices. Almost all of them borrowed to buy the stock when prices were much higher. The result: they now would be unable to pay off the loans by selling their shares.

Ratio: Overall, Edper’s public companies have paid out the equivalent of 70 per cent of their income in dividends over the past five years. That ratio is high compared to the 50-percent average for other large companies listed on the Toronto Stock Exchange over the same period. But to help meet its commitments, Edper has also redoubled its efforts to raise cash from other sources. According to Harding, Edper has raised $10 billion in new capital over the past two years. Approximately $2 billion of that came from selling new equity issues. But $5 billion came from new debt issues, and $3 billion arose from asset sales. Those sales are continuing. In recent weeks, beleaguered Royal Trust has announced plans to sell off the Seattlebased Pacific First Bank and Trizec has announced plans to sell off a stake in a Maryland shopping mall.

Some of Edper’s hardest-hit companies have also bitten the bullet and reduced or eliminated their dividends, including Bramalea Ltd. and Royal Trust. But Canadian Bond Rating Service’s Neysmith, for one, said that Edper management has waited too long to take action. “They have used a lot of equity financing over the past two years to pay the dividends,” he said. “That can only go on for so long.”

Last week, Harding said that the group still prefers to set its dividends “at levels which are sustainable throughout a normal economic cycle.” Indeed, the whole structure and management philosophy of the Edper empire are designed to function during a normal cycle. But as the general economic slowdown continues, it is increasingly difficult to adapt the company to a cycle that looks less and less like a normal one.

JOHN DALY