It is interesting to see the divergence in valuations for commercial real estate in the private versus public markets. In transactions between private property owners, valuations have declined slightly over the last year, but by much less than the valuations for publicly traded real estate investment trusts (REITs).

Real estate valuations are often measured in terms of a capitalization rate which equals the net profit before interest, taxes and depreciation generated by a property divided by total purchase price. This ratio is expressed as a percentage yield. Implied capitalization rates for public REITS have skyrocketed as their publicly traded unit prices have plunged. The interesting thing is that generally speaking private real estate owners have as yet not been willing to sell properties for capitalization rates anywhere near as high as those implied by REIT unit prices.

The situation with RioCan REIT offers a good example of this valuation discrepancy. RioCan is among the largest, most respected REITs in Canada and owns more shopping centres than anyone else in the country. Its publicly traded unit price has declined over 50% from its peak and based on its current unit price its real estate portfolio is being valued at a capitalization rate of approximately 8.5%. RioCan’s shopping centre portfolio could not really be assembled by other parties given its size and quality, but suffice it to say that much lower quality individual retail properties are changing hands among private buyers for prices which imply capitalization rates between 6.5% and 7.5%. This gap in percentages may seem minor but it actually equates to very significant differences in valuation at the end of the day.

On the one hand, one would expect properties held by REITs to command higher valuations than privately held portfolios as on average REIT properties are probably of higher quality and the REIT structure offers investors more liquidity. However, the other side of the story is that many REITS are overleveraged and investors may rightfully be concerned about refinancing risk, which is depressing valuations. REIT unit prices also represent minority interest valuations which should be lower than the valuation for the purchase of an entire property (which carries with it a control premium).

Either way, it would seem that the valuation gap between public and privately owned commercial real estate is likely to disappear. Our belief is that valuation in the two markets is likely to meet in the middle over the next 12 to 24 months. We think public market investors have overreacted and that REIT prices will rise to some extent (perhaps 20%+) and that private market real estate valuations will drop as real estate entrepreneurs are forced to refinance mortgages on more onerous terms and come to grips with the fact that their portfolios have declined in value.

On January 1, Canadians who are 18 years of age or older will be able to take advantage of possibly the most significant change to Canada’s savings system since the introduction of the RRSP in 1957. Introduced in the 2008 federal budget, the Tax-Free Savings Account allows individuals to contribute up to $5,000 annually for any savings purposes. The main benefit of a TFSA is that income generated in a TFSA (including interest, dividends and capital gains) is earned on a tax-free basis.

The annual TFSA contribution limit will be indexed to inflation and rounded (up or down) to the nearest $500. A wide range of investments can be held in a TFSA including GICs, publicly traded stocks and bonds and cash.

TFSAs differ from RRSPs in several ways. Unlike contributions to an RRSP, money deposited to a TFSA is not tax deductible; at the same time however, withdrawals are not taxable. Funds can be withdrawn at any time from a TFSA without restriction. And to the extent funds are withdrawn, the same amount can be re-contributed in subsequent years along with any unused past contribution room.

While the annual amount which may be contributed to a TFSA is relatively small at $5,000, the amount which can be accumulated in TFSAs over a long period of time can be substantial, especially for younger individuals.

For example, based on an estimated 2% annual inflation rate, a 30 year old individual who makes their full TFSA contribution at the start of each year for 40 years would be able to make cumulative contributions of approximately $312,000 (remember that the $5,000 annual contribution limit will increase by inflation in $500 increments). Assuming a relatively conservative annual investment return of 5%, the individual’s $312,000 of contributions would grow in value to approximately $895,000 by the time they reached 70 years of age as a result of the magic of tax free compounding of investment returns. A married couple where both partners made the maximum annual TFSA contributions would be able to accumulate twice that amount or almost $1.8 million in total.

Don’t forget that the best thing about accumulating this level of savings in a TFSA is that the funds can be withdrawn at any time on a tax free basis. So, in our example above, the couple would be able to withdraw some or all of their $1.8 million in savings when they reach 70 (or earlier) without paying any income tax! Clearly, if utilized consistently over a long period of time, TFSAs can represent a significant source of retirement income.

After all that has happened, it is hard to believe that the BCE buyout is now likely to get scuttled by accountants! By now, everyone knows that a little-noticed clause in the purchase agreement required BCE to pass a solvency test administered by accounting firm, KPMG. The solvency clause was presumably requested by the purchasers for their benefit or inserted at the behest of the banks who have committed to finance the deal.

Several corporate lawyers with whom we have consulted suggest that it is unusual to see a solvency test in a buyout deal, which us leaves uswondering whether the buyer’s legal counsel may have shrewdly insisted on the clause to provide their clients with a potential way out of the transaction.

A more likely scenario may be that the solvency test was put in the agreement to satisfy existing BCE bondholders who have seen the value of their bonds plummet on the expectation that the deal would close and their bonds would be re-rated as junk. The solvency clause could have been inserted by BCE’s buyers to placate the existing bondholders and demonstrate that their interests were being considered in the transactions.

Either way, one wonders why BCE and its lawyers ever agreed to the solvency condition. The financial backers of the buyout, namely the banks, Ontario Teachers’ Pension Plan and several US private equity shops, don’t need KPMG to advise them on BCE’s solvency as those parties are all essentially in the business of assessing investment risk. And if BCE’s buyers anticipated issues with existing bondholders, then an arrangement with those bondholders should have been worked out beforehand to ensure they were properly protected instead of inserting a bogus solvency condition into the purchase agreement.

BCE and its lawyers also should have paid closer attention to the definition of solvency used in the purchase agreement. Specifically, the original purchase agreement dated June 29, 2007 defines insolvency to mean:

“…. as of any date of determination (a) the amount of the fair saleable value of the assets of the Company will, as of such date, exceed (i) the value of all liabilities of the Company, including contingent and other liabilities, as of such date, as such quoted terms are generally determined in accordance with Applicable Laws governing determinations of the insolvency of debtors, and (ii) the amount that will be required to pay the probable liabilities of the Company on its existing debts (including contingent and other liabilities) as such debts become absolute and mature, (b) the Company will not have, as of such date, an unreasonably small amount of capital for the operation of the businesses and transactions in which it intends to engage or proposes to be engaged following the Effective Date, (c) the Company will be able to meet its obligations as they generally become due and to pay its liabilities, including contingent and other liabilities, as they mature, and (d) the aggregate of the property of the Company is, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would be sufficient, to enable payment of all its obligations, due and accruing due. For purposes of this definition, “not have an unreasonably small amount of capital for the operation of the businesses in which it is engaged or proposed to be engaged” and “able to pay its liabilities, including contingent and other liabilities, as they mature” means that the Company will be able to generate enough cash from operations, asset dispositions or refinancing, or a combination thereof, to meet its obligations as they become due”

In a nutshell, the definition essentially means that in order to be considered solvent, (i) the “fair saleable value” or “fair valuation” of BCE’s assets must exceed its liabilities and (ii) the company must be able to meet its obligations as they become due. This seems to be a reasonable definition of solvency except that the terms “fair saleable value” and “fair valuation” are not clearly defined which strikes us as a tad sloppy on the part of the lawyers involved given the size of this transaction. Even in much smaller private equity transactions, these terms relative to asset valuations are often carefully defined so that unexpected surprises are avoided down the road. In BCE’s case, it appears the parties decided to leave the interpretation of “fair value” and “fair saleable value” in KPMG’s hands, much to the detriment of BCE and its shareholders.

While we can’t be certain, it is widely believed that KPMG’s view is that BCE does not meet the first solvency requirement above, namely that the value of its assets exceeds its liabilities (including the new debt required to fund the buyout). The question is how did KPMG determine the fair value of BCE’s assets? We can only speculate, but it is likely that the firm estimated the value of BCE by applying a multiple to the Company’s earnings before interest, taxes, depreciation and amortization (EBITDA). This is a common approach used by private equity firms and other investors to value businesses, particularly telecom companies like BCE.

The total value of the BCE buyout is $52 billion based on the amount of the company’s existing debt and preferred shares plus the value of BCE’s common shares at the $42.75/share offer price. The purchasers are financing the transaction with approximately $8 billion of equity and $44 billion of new and existing debt (including a small amount of existing preferred shares). Based on BCE generating approximately $7 billion of annual EBITDA, the buyers purchase price of $42.75 per share equates to a valuation of approximately 7.5x EBITDA for the company’s assets.

The crux of the matter here is that KPMG obviously believes that the buyers are overpaying for BCE’s assets and that the value of the business has substantially declined since the parties agreed to the deal terms.

In order to arrive at value for BCE’s assets in excess of the company’s $44 billion post-transaction debt load, KPMG would have to value BCE using an EBITDA multiple of at least 6.3x (i.e. $44 billion of debt divided by $7 billion of EBITDA). If KPMG believes that BCE’s assets are worth less than 6.3x EBITDA, then BCE’s assets are worth less than its liabilities and the company does not pass the solvency test. Another factor for KMPG may be that BCE’s pension plan is apparently significantly underfunded which, at least theoretically, adds to BCE’s debt load.

In selecting an appropriate EBITDA multiple to value BCE, KPMG would have probably looked at publicly traded valuations of other telecom companies. Firms such as Telus and Manitoba Telecom are currently valued by stock market investors at approximately 5x EBITDA, while Rogers Communications trades at approximately 7x EBITDA. Now, not all telecom firms are alike. These companies each operate in various segments such as wireless, wireline and cable. Wireless and cable businesses are generally valued using higher EBITDA multiples as compared to the wireline businesses which are losing customers and suffering from price declines due to competition. For example, Roger’s commands a higher EBITDA multiple from stock market investors because most of its profit comes from wireless and cable which are stable and growing businesses.

If the stock market is currently saying that the assets of telecom firms are worth between 5x and 7x EBITDA, then a case could be made that BCE’s assets should be valued at the low end of this range as a significant proportion of the company’s earnings come from the declining wireline telephone segment.

KPMG’s position is ridiculous, however, in that stock market values today are incredibly depressed and it is unlikely that anyone would agree to sell BCE in its entirety for less than 6.3x EBITDA. This is especially true because BCE has been poorly managed and there are numerous opportunities to improve earnings though better service and eliminating layers of redundant management.

In valuing BCE’s assets at less than 6.3x EBITDA, it seems that KPMG has also not taken into account the fact that publicly traded telecom share prices do not reflect the price investors would pay to take over a company in its entirety. Normally, a takeover of a publicly traded company would occur at a substantial premium to the current trading price.

BCE’s legal counsel should have insisted that fair value be defined in the purchase agreement to include an appropriate takeover premium. Counsel might also have insisted that fair value be determined in the purchase agreement using a minimum EBITDA multiple of 6.5x to 7.0x to avoid having the entire transaction rest on KPMG’s view of an appropriate EBITDA multiple to use for valuation purposes.

It is obviously easy for us to make these comments in hindsight but given the cost per hour of BCE’s advisors someone clearly should have foreseen this negative outcome. To watch this entire deal fall apart based on KPMG valuation methodology is ridiculous.

While there may be more to this story than our analysis suggests, it seems unlikely the full story will ever come to light. Whatever the case, the BCE deal seems destined to die and will likely serve as a high profile reminder of the end of a great bull run in private equity.

This is the first post to our new blog at Bridgeport Asset Management. We plan to use the blog to communicate our thoughts and opinions on a range of subjects including investments, personal finance, business, the economy and current events. We hope you find out posts interesting and useful. Please feel free to send us your comments as we always appreciate hearing from you.