FW speaks with Richard Farr, a partner at BDO, about the treatment of pensions in M&A.
FW: Pensions are now a structuring and pricing issue for both buyers and sellers in M&A transactions. What risks in particular must parties consider?
Farr: The potential for a material deterioration of the employer covenant post the transaction, caused by increased leverage and group reorganisations driven by tax planning, could lead the trustees to demand a higher technical provision and higher cash funding. They may also alter their investment policy to one of less risk, which creates a higher funding requirement as well. In a worst case scenario, the trustee is well within its rights to also demand the full S75 (buyout) liability to be settled in full.
FW: How important is it to conduct effective pensions due diligence? Do you believe acquirers pay enough attention to this aspect when pursuing a deal?
Farr: Pension risk is one of a number of key risks which an acquirer needs to assess. This area is often overlooked in the initial stages because acquirers do not understand the pension issue. They prefer to focus on the core operational and business risks with which they are familiar. However, pension obligations can often be so large as to swamp any operational risk issues and may be a dealbreaker but are not discovered until well into the process. It is therefore vital for an acquirer to properly understand the pension risks it is taking on. Current particular issues can involve data and equalisation. Data can be very poor quality and will lead to an increase in liability if the company wants to buy out the liabilities. We have found data issues can result in an increase in liabilities of up to 5 percent. It is also not uncommon to find that, historically, equalisation of benefits was not done properly. This can result in an increase in the liabilities of 10-20 percent.
FW: What steps should an acquirer take once it determines a target company’s full liabilities arising from pension plans or other long-term obligations such as retiree health benefits? To what extent can it use this information to adjust the offer price to better reflect the reality of the deal?
Farr: This will depend on the acquirer’s attitude to pension risk, and whether they have their own pension risk exposure. Actually, the pension fund can effectively provide additional leverage for any acquirer in a transaction. In the first instance, this risk can be used to reduce the price to reflect the additional ‘risk’ taken on. However, what is proposed for negotiation may not be the real appetite for taking that risk. If an acquirer is bullish on equity market returns and also thinks that gilt yields will ‘normalise’ during the period of their ownership, then this ‘leverage’ can be used to obtain a substantial price reduction, whilst at the same time the risk associated with that reduction does not have to be recognised in the group post balance sheet forecast.
FW: In what ways can firms manage the impact of pension liabilities on the deal process? How can parties structure an M&A transaction – for instance through a share or asset purchase – to specifically address and potentially avoid pension plan liabilities?
Farr: There has to be immediate and full disclosure of the pension issues in the data room. This will avoid any surprises later on. Structuring a transaction with and without the pension scheme should also be done at the planning stage. Scheme liabilities are normally unsecured creditors of employer companies. The only difference compared to other unsecured creditor solutions is that this liability can change as a result of the acquirer’s actions. Also, the employer liability may not be the specific target group’s liability, and separating these two distinct elements is important.
FW: Firms can encounter one of three common types of pension arrangement: a group personal pension plan, a defined contribution pension scheme or a defined benefit pension scheme. What particular liabilities does each type of pension plan present?
Farr: From an M&A perspective, a group personal pension plan (GPPP) or defined contribution (DC) pension scheme will have no past service liability obligations, and therefore only a cost element in any P&L analysis (not balance sheet). As a result, GPPPs and DCs were often ignored as immaterial. However the advent of auto-enrolment (AE) has meant that due diligence should be done to assess a vendor’s financial projections to ensure that they have fully allowed for the impact of this new ongoing cost.
FW: What new ideas and solutions do you see emerging in M&A deals involving defined benefit (DB) pension plans?
Farr: The key to any new solution is to recognise the underlying economics of the situation. Pension schemes can be so material to a target’s valuation that the trustees have to have a significant stake in the success or otherwise of the transaction. Giving trustees protection through mitigation over a variety of employer assets (for example, via Scottish Limited Partnership structures) as a well as equity upside – either based on the transaction itself (which requires careful planning before) or more likely, as part of the post transaction exit strategy, has to be the obvious thing to do. There are now tools in the marketplace to achieve these objectives.
FW: What steps should an acquirer take to engage with Trustees of a target firm’s pension scheme? How can this benefit the acquirer during the transaction and beyond?
Farr: As an acquirer, engage as early as you can and agree a Memorandum of Understanding which can calibrate the trustees’ view of any change in the employer covenant as a result of the transaction. Trustees are a partner in this process, not just a material creditor, and understanding their views of the employer covenant pre and post deal will be essential. By engaging early, the relationship can be firmly established to carry on after the transaction. However, the acquirer does need to have a detailed strategic, tactical and operation plan to share with the trustees as part of this new relationship. If the acquirer is not allowed access to the trustees – do not do the deal.
FW: Substantial pension liabilities can often put off prospective buyers. What steps can sellers take to attract greater interest, where they have such pension liabilities?
Farr: Sellers need to understand all available pension deficit reduction techniques and have either implemented them or have a plan, with trustee agreement, to implement them. Any informed acquirer will also have these available, so it is important to take this pricing arbitrage off the table to allow for a clean price to be negotiated. Scheme funding negotiations should also have been finalised and, if more than two years old, the seller needs to accelerate the next one so it is not a dark cloud during the transaction, which is a recipe for disaster. Understanding the trustees’ view of the employer covenant in that process is also essential, as well as how sensitive to changes the funding deficit is in that covenant.
FW: Pension liabilities are often an impediment when it comes to valuation on the sell-side. How can sellers prepare their business for sale while avoiding with a large price reduction for pensions?
Farr: If there are multiple buyers, a comprehensive vendor due diligence report with all the relevant pension information is essential. This allows the vendor to react proactively if any obvious pricing issues emerge, as well as ensuring that the phase two bidders do not use ‘new information’ to try and renegotiate indicative terms. Also, obtaining a Memorandum of Understanding (MoU) with the trustees is essential. This MoU can then be placed in the data room which can give first phase bidders an opportunity to price the pension risk based on their own funding and tax strategies. Clearly there can be no fettering of powers in the process, and the devil will be in the detail – however, the presence of an MoU will demonstrate the commercial and technical credibility of all parties.
FW: What recent changes, if any, have you seen in pension legislation and regulation? How has this impacted the M&A process where pension liabilities are an issue?
Farr: There have been no material changes to pension legislation which affect M&A, and none are expected. What is happening, however, is that the Pension Regulator is under enormous pressure from industry and government to be more flexible in its funding rules and regulations. The regulations and guidance notes were written in a different market – when the Scheme was a creditor. In the majority of case now, the Scheme needs to be seen a partner. Whilst this has caused uncertainty in the deals marketplace, the Pension Regulator is starting to show more flexibility in its behaviour – see, for example, UK Coal, which was allowed an OpCo and PropCo split, and Kodak, where the Scheme became a material investor in the employer’s US subsidiary. This is good news for M&A because the presence of a DB scheme has, until recently, prevented a number of deals. New techniques and more flexible and informed trustees will mean a much more liquid market in DB related transactions.
Richard Farr leads the BDO Pension Business Advisory team on diverse and significant transactions such as Uniq plc (Employer) and AEA Group plc (Trustee) as well as numerous mid-market covenant reviews including General Motors (Employer) and EDS (Trustee), compromises and regulatory defence assignments. Formerly Head of Pensions at Swiss Re from 2007 to 2009, Mr Farr was responsible for assessing pension risk transfer opportunities. Prior to this, Mr Farr was a Partner at PwC and led the Pension Corporate Advisor Team from 2005 to 2007 where he advised the PPF on its initial risk-based levy and Pension Regulator on its original Clearance Guidance rules. He can be contacted on +44 (0)77 6490 3060 or by email: email@example.com.
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