Why restaurant royalty funds are sizzling, and the case of the negative ACB

Now that Fairfax Financial Holdings Ltd. (FFH) has signed a letter of intent to acquire The Keg Royalties Income Fund (KEG.UN), do you think other restaurant royalty companies will be bought out?

There does seem to be a trend of restaurant parent companies acquiring their royalty affiliates. In October, A&W Food Services of Canada Inc. merged with A&W Revenue Royalties Income Fund, citing “a more conventional capital structure that can be leveraged to finance growth initiatives.” The combined company now trades on the Toronto Stock Exchange under the symbol AW.

This week, Keg Royalties announced it has signed a letter of intent that would see Fairfax Financial acquire all outstanding units of the fund, other than those it already owns, for $18.60 each – a 31-per-cent premium to the price before the proposal was announced. The Keg steakhouse chain is owned by Recipe Unlimited Corp. – parent of Swiss Chalet, Harvey’s, East Side Mario’s and other brands – which was taken private by Fairfax Financial in 2022.

Based on recent stock market action, some investors may be betting that other royalty companies could eventually get swallowed up. In the three trading sessions following the Fairfax-Keg announcement on Monday morning, shares of Pizza Pizza Royalty Corp. (PZA) rose 2.3 per cent and units of Boston Pizza Royalties Income Fund (BPF.UN) gained 4.5 per cent. Both chains also released first-quarter results this week, with same-store sales rising 1.2 per cent at Pizza Pizza and 4.4 per cent at Boston Pizza.

Royalty funds are unusual in that they don’t own the restaurant chains themselves. Rather, they own the restaurant trademarks, which they license to the operating company in exchange for a royalty based on a percentage – typically 4 per cent to 9 per cent – of sales by restaurants in the “royalty pool.” That royalty income, in turn, funds cash distributions to shareholders.

The high yields of royalty stocks make them popular with retail investors. Keg Royalties and Pizza Pizza Royalty both yield more than 6 per cent, Boston Pizza Royalties yields more than 7 per cent, and SIR Royalty Income Fund (SRV.UN) – owner of the Jack Astor’s casual dining chain – yields about 9 per cent.

Although restaurant royalty funds share a similar structure, each has its own characteristics. Pizza Pizza Royalty, for example, is a corporation, not a fund like the other entities.

In the case of Boston Pizza, the “operating company has a single individual owner in Jim Treliving,” said Nick Corcoran, an analyst who covers Boston Pizza Royalties at Acumen Capital. “It would ultimately be up to Mr. Treliving to pursue a sale of the operating company or combination with the income fund.”

I wouldn’t invest in a royalty fund based solely on expectations of a buyout. It’s more prudent to consider the investment’s merits on their own and treat any potential transaction as a bonus. In other words, enjoy your main course of dividends, but don’t expect a free dessert.

In my tax-free savings account and registered retirement income fund, I have been holding some Brompton investment funds for 14 years. My Brompton Life & Banc Split Corp. Class A shares (LBS) show a negative book value of $3,547. My purchase cost was $32,135, and the current market value is $31,814. My annual yield is about 14 per cent. What would happen if I sold the fund in this negative book value situation? Would it reduce my gain?

The negative book value will not affect the proceeds you receive from selling your shares. Assuming you enter a market order to sell (as opposed to a limit order that specifies your asking price), the price will be determined by the bids available at the time.

Keep in mind that, because bid and ask prices are constantly changing, the price you receive may differ slightly from the price of the previous trade.

Nor will the negative book value have any tax consequences in your case. Because you hold the shares in a registered account, you will not face any taxes on capital gains or investment income.

The only time an investment’s book value – also known as adjusted cost base (ACB) – comes into play for tax purposes is when the securities are held in a non-registered account. In such cases, you would calculate your capital gain (or loss) by subtracting the book value from the sale proceeds.

Hypothetically speaking, say your shares were held in a non-registered account and you sold them for proceeds of $31,814. You would have a realized capital gain of $35,361 (calculated as $31,814 minus the ACB of negative $3,547, which is the same as adding $3,547).

You may be wondering where the negative book value came from. Well, if you own an investment that distributes return of capital (ROC), as LBS and many other high-yielding funds do, each ROC distribution must be subtracted from your ACB. (Evidently, your broker has been doing this for you.) If you receive enough ROC over the years, your book value can drop to zero.

In a non-registered account, once the ACB or book value hits zero, any subsequent ROC distributions are taxed in the same year as capital gains and are no longer deducted. So, in a non-registered account, the book value cannot technically drop below zero. But as you’ve discovered, in a registered account it can and does happen.

Disclosure: The author owns PZA, BPF.UN and KEG.UN personally.

E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.