The 2004 Pensions Act made trustees personally accountable. It empowered them to push for maximum security in M&A transactions that impact the corporate covenant. Against a backdrop of sharply reduced covenants in leveraged buyouts, private equity acquirers have routinely found it necessary to engage with trustees to avoid the possibility that they might impede the process. However, to date there has been little evidence that the legislation itself has obstructed corporate activity, particularly where a pension scheme's FRS17 liabilities are fully-funded. Companies that have under-funded schemes, meanwhile, are now often passed over as unsuitable targets by private equity acquirers.
WHAT POWERS DO TRUSTEES HAVE?
Trustees are increasingly seeking more certainty. When faced with the risk of a reduced sponsor covenant, they will first focus on the size of their scheme's liabilities both in absolute terms and relative to the size of the sponsoring company. If the scheme is in deficit they will then be concerned about how that deficit ranks against other creditors to the company, following the levering up of the balance sheet. Supported by the Pensions Regulator, trustees have three key tools to help them:
However, in practice, very few corporate transactions have run into real difficulties. The Regulator has sought to avoid being an impediment to corporate activity, stating that clearance is not a requirement and only really recommended where a pension scheme is in deficit, as measured under FRS17 accounting rules. The settling of a Section 75 debt can often be put off through a withdrawal arrangement, but this raises the need for approval by the Regulator whether the scheme is in FRS17 deficit or not.
At the time of the recent acquisition of Alliance Boots by KKR, the target's pension scheme reported a small FRS17 surplus. The trustees were only given a forum to demand a contribution into the pension scheme through the court hearing for the approval of the Scheme of Arrangement. If that transaction had instead been structured as an offer, the trustees might not have had the power to call for a contribution by KKR.
CAN'T PRIVATE EQUITY ACQUIRERS SIMPLY IGNORE THE PENSION SCHEME?
If regulation does not force a contribution to the pension fund, usually because the scheme is not in FRS17 deficit, why do private equity acquirers concern themselves with the demands of trustees? The reasons, in practice, are more subtle and situation-specific than practitioners predicted when the legislation was introduced.
Firstly, individual scheme rules may grant the trustees more power to call for employer contributions than statute requires.
Secondly, even if the FRS17 position is neutral or in surplus, the pension scheme may hold significant investment and mortality risks which could increase the liabilities. Trustees' powers under SSF rules give them greater influence over the assumptions used and the right to call for increased contributions following the acquisition. Therefore, the pension represents the source of an ongoing, unquantifiable balance sheet liability for the new acquirer, dependent on future trustee behaviour.
Thirdly, the trustees' increased accountability will cause them to seek out ways of increasing certainty for their members as the covenant is weakened. The Alliance Boots transaction (where trustees used the scheme's status as a creditor to the company at the court hearing), is an example of where trustees might seek to make their influence felt. For many trustees, the benchmark for evaluating scheme liabilities is the cost of buying out the pension scheme or perhaps more conservatively, a methodology that uses gilt yields minus a margin to discount liabilities. Where a Section 75 debt is triggered, the valuation methodology can have a significant impact on the economics of the transaction.
Finally, and perhaps most significantly, private equity acquirers take on the unquantifiable risks that the rules for measuring pension liabilities will become more conservative than FRS17 and/or that trustees' powers may be strengthened further. The rules around Section 75 and “abandonment” have been clear indicators of the potential for such change.
IS THERE AN ALTERNATIVE?
Many private equity acquirers are seeking ways of reducing or removing the risks associated with a pension scheme before a transaction takes place. In particular, where the scheme's deficit to buyout cost is below the negotiated Section 75 debt, removal of all risks by transferring the scheme to an FSA-regulated insurer can be an attractive alternative if the Section 75 debt has to be fully funded.
The funding of a Section 75 debt is an expense of sale and is often not tax-deductible, whereas funding the deficit to buyout cost is – making it more attractive by comparison.
The risks associated with a defined benefit pension scheme can be transferred off the balance sheet of its sponsoring employer through a full buyout of the scheme with an insurance company. If this is done at the same time as the scheme wind-up, the full buyout brings complete separation from the sponsoring employer and a statutory discharge for the trustees. Where a Section 75 debt must be funded and the deficit to buyout cost is below this debt, it may be best to carry out a full buyout just prior to the acquisition of the business, particularly given the tax rules.
In cases where it is not necessary or financially attractive to undertake a full buyout, other flexible structures that allow the separation of pension scheme risk from the sponsoring employer are being offered by insurers. For example, a progressive buyout programme might be carried out over a number of years. These can be tailored to the cash flow plans of the business and can also allow flexible investment strategies to be implemented during the term of the buyout while locking in a fixed mortality pricing basis. Insurers can also often incorporate reductions in the buyout cost over time, based on scheme member behaviour or liability management exercises.
Buying out all or some of the liabilities of a pension scheme with a regulated insurer brings significantly greater certainty for pension scheme members than would be available from the sponsoring employer following the diminution of covenant in a leveraged acquisition by a private equity firm.
Ultimately, it is only through complete separation that investment, mortality, reporting and regulatory risks can all be removed and the value of the acquired operating business be maximised.