The minority investors in Foremost Income Fund may be bitterly unhappy but they haven't lost their sense of humour. You've heard of the takeover? They're calling what's happening to their trust a "takeunder."
A takeunder is when the trustees of your fund decide to delist it from the stock exchange. The trustees of Foremost say they're making this move to avoid paying tax at the trust level. But some minority investors suspect there are other motives afoot - such as allowing insiders to get the company at a bargain price.
Foremost makes and sells gear for the oil field drilling industry. It's well run but small, with a market value of only about $120-million. But it just put itself on the map with its delisting move, which is unprecedented according to trust lawyers. It's taking advantage of the fact that an income fund that is not traded on a public exchange can continue on its merry tax-avoiding way even after Jan. 1, provided it meets certain criteria.
Foremost announced its decision last Thursday. As you might imagine, it didn't sit well with many shareholders who will soon be unable to buy or sell units in the market. Those units, which had been hurt by the slowdown in gas drilling but which were starting to recover nicely, lost 15 per cent of their value on unusually high volume when the fund revealed its plan.
Foremost's trustees say that the delisting move is in the best interests of unitholders, although they acknowledge that the resulting lack of liquidity is a serious issue. To mitigate the effect, the fund is offering to redeem up to $1.5-million units a month once it delists, and to redeem an extra $3-million of units in the first two months after it delists.
But the redemption process poses problems for minority owners. First, the redemption price will be based on the fund's tangible book value plus or minus 10 per cent, at the discretion of the trustees. The initial price will be $6.40. That's lower than the market price of the fund before this decision was announced, by about 5 per cent or so.
A more important problem is that Foremost's move takes away much of the profit potential for minority investors. A good business whose prospects are improving will often trade at more than book value, sometimes a lot more. But the delisting move removes the possibility of investors selling at a big multiple of book value.
Foremost's business is very cyclical. In good times, such as from 2002 to 2008, it averages return on equity of about 35 per cent, according to Capital IQ. Return on equity was 58 per cent in 2006. In bad times it can be low or slightly negative. On average, though, the returns are very good. As such, the stock sometimes trades at a very big multiple to book value. Foremost units traded as high as seven times book value in 2006.
Investors often find it profitable to buy good but cyclical businesses at the bottom of the cycle, when they can be had for a discount to book, and sell them at the peak for a multiple thereof. Foremost investors won't be able to sell at such a price, at least not without nearly prohibitive difficulty. (They can try to find a buyer privately, but that's not likely).
Creeping Takeover
Investors will vote on management's idea in November. But most won't bother. Why? Because Jim Grenon, a trustee, owns more than half the stock and his friends and associates own more yet - enough to get them the two-thirds they need or close to it. This is Mr. Grenon's idea and he's going to have his way.
The move looks like a creeping takeover. Foremost is in great shape, with more than $30-million of cash on the balance sheet and what looks like improving prospects.
So how is this delisting good for shareholders? It clearly isn't good for all of them, given the market's reaction.
I asked Mr. Grenon why he didn't just make an offer to buy out the minority shareholders, as others in his position have done. His response: "Because I don't want to."
Nor does he have to, more to the point. The fact is that it's not necessarily in his best interests to do so. It's expensive because he'd have to pay a premium, although it looks like he could do that and still get a good deal. But he might not be able to keep the fund's tax-free status if he did so.
Mr. Grenon says not all minority shareholders are unhappy. He believes Foremost makes a good investment even as a private company. He acknowledges that investors won't be able to buy low and sell high in the market but they'll get tax-efficient distributions.
Ultimately, though, the problem is that investors have had the rug pulled out from under them. They didn't expect this and are now stuck, either forced to sell, perhaps at a loss, or trapped in an illiquid investment with no ability to make the kind of capital gain they hoped for. Many will sell, and others will ultimately redeem, meaning the ownership of insiders will go up at a relatively bargain price.
Mr. Grenon points out that the investors owning a majority of the stock, even though they're a small number of people, want this. He's right.
But a majority of investors likely don't want it, although there's nothing they can do.
Such are the risks of investing in companies with controlling shareholders. Insider ownership is often viewed as a good thing, but it doesn't guarantee that the interests of all shareholders align.