Several high-profile deals in 2007 revealed that pension liabilities remain a hurdle for buyout firms completing acquisitions in the UK. For example, KKR had to commit an additional £1 billion ($2.2 billion) to the pension scheme of chemists Alliance Boots in order to seal the shareholder-approved deal. The buyout firm promised £418 million in cash installments over the next decade and a £600 million security agreement. Later in the year, Qatari-based private equity firm Three Delta walked away from its bid for UK supermarket chain Sainsbury's after the trustees requested an additional £500 million ($1 billion) to further secure the scheme.
The demand for such payouts – and the possibility of bids stalling as a result – may be inevitable at times, but there are steps a bidder might take to avoid them. First and foremost, experts suggest that buyout firms sit down with trustees as early in the process as possible. This displays a willingness to address their concerns, and contradicts trustees' bias against the industry, cultivated by biting editorials from the press and diatribes from union leaders.
However, when bidders sit down with trustees, they need to be armed with their own assessment of the liabilities in order to argue their case. Negotiations should be friendly but substantive, to demonstrate how the buyout will protect the scheme by growing the enterprise, and that the firm takes its pension responsibilities seriously enough to commission its own assessment. If the firm strikes the right tone with sufficient evidence to support its case, the trustees may grant their blessing without demanding punitive contributions, or turning the issue over to the Pension Regulator.
Offer a seat at the table
“The most important thing is to offer the trustees a place at the table. If you ignore them until things are signed there will be trouble,” says Rosalind Connor, a partner in the London office of law firm Jones Day. “You need to see the whites of their [trustees'] eyes. Don't let the management company keep you from sitting down with them. Sometimes just starting that one-on-one dialogue is enough.”
Several lawyers warned that the bidder should not rely on the management of the company to act as a go-between between them and the trustees. Some noted that management is looking for speed in the auction process and the trustees tend to slow things down. “Pension time is different from deal time,” says Joanne Etherton, an attorney in the London office of Weil, Gotshal & Manges. She suggests meeting with trustees as soon as preferred bidder status has been established. “Before delving into details, make sure confidentiality agreements are in place with the trustees,” says Connor.
Lawyers and pension fund lobbyists agree that bidders should expect an adversarial attitude from trustees, at least at first. “There is some concern [private equity] groups are simply asset strippers,” says David McCourt of the National Association of Pension Funds (NAPF), a group that lobbies on a range of pension issues on behalf of many UK schemes.
Connor notes that financial engineering is particularly unnerving for trustees, as additional debt jeopardises the solvency of the scheme. Etherton adds: “If the new owner is based outside of the UK, trustees may be concerned as to the enforceability of the UK Pensions Regulator's powers and ask for additional comfort on the change of control in the form of a cash injection or guarantees.”
To dispel such worries, advisors from both buyout and pension camps suggest sharing the plans for the business in question. “Talk about injecting life, building the business up, buying new machinery and the like. Stress that you see the potential of the market. The trustees don't want investors to suck money out of a business without enriching the assets to pay them,” says Connor. She suggests bringing case studies of how previous investments and relevant pension schemes have fared. “A track record can go a long way to dispel their assumptions.”
“Before negotiating with trustees, know what their powers are under the governing trust. Could they demand funding on a buyout basis or even wind-up the plan due to change in control?”
The eye of the beholder
Right or wrong, assumptions are at the heart of any debate over pension liabilities as they're calculated using a variety of methods, including some more conservative than the one developed by the International Accounting Standards Board (IASB), IAS-19.
“Trustees are more inclined to look initially at an actuarial study where they have their own actuary develop the numbers, from their own assumptions of expected return of pension investments, of enrollee life expectancy and other pension liabilities, of early retirement, etc, before they consider any pensions evaluation from a private equity consortium,” says McCourt. Trustees often do their analysis on a three-year basis, and any change in ownership may prompt yet another calculation.
“PE houses should not be frightened to suggest that trustees shouldn't alter plans of how the scheme is structured or bolstered,” says Connor. “Use the dialogue with trustees as a chance to confirm that they agree that their previous valuations will be fixed at this point – even if you can't get anything more binding.” One lawyer stresses the importance of getting early access to the trustees' evaluation of liabilities, not just management's. These can differ widely. The lawyer cites an example where the number from the IAS-19 calculation was a third of the trustees' assessment.
“PE firms need their own actuarial and legal advice on the pension issues before they meet with the trustees. They are then armed with their own assessment of the impact of the transaction on the employer covenant and the pension plan and can have a strategy for negotiation with the trustees which works within the deal structure,” says Etherton. One lawyer explains that an actuarial study more conservative than current management's may strike the right tone for the entire negotiation.
The other facet of negotiations that several lawyers stress is the need to know just what power the trustees wield. “Before negotiating with trustees, know what their powers are under the governing trust. Could they demand funding on a buyout basis or even wind-up the plan due to change in control? Trustees are likely to negotiate hard and there may be threats of drastic action, but you need to know what they could actually do to you if you fail to reach agreement,” says Etherton. “Older pension schemes tend to have more protections for the members with some anti-predatory clauses, but it varies from scheme to scheme.”
Knowing a trustees' actual powers and analysis of liabilities may allow for informed responses should negotiations head south, but many lawyers stress that sitting down with the trustees and preemptively answering their concerns can avoid such arguments altogether. “You need to have a relationship with the trustees. They frequently view private equity as quick-fix artists who may destabilise the business, and bidders need to disavow them of this belief immediately,” says Connor.
US GPs, mind those shortfalls
UK buyout firms are not alone in being sensitive to pension liabilities. Their US peers have always paid close attention to the pension programs at target companies, but recent statements by the Pension Benefit Guaranty Company (PBGC), the federal body that assumes responsibility for failing programs, should make them even more mindful of liabilities. Private equity firms with a single fund holding an 80 percent or higher stake in a portfolio company could be liable for pension shortfalls at the enterprise.
“Last September, the PBGC reaffirmed their position that private equity firms can be responsible for the pension liabilities of their portfolio companies,” says Jonathan Lewis, a partner at the law firm of Debevoise & Plimpton. “While this has always been their view, the official statement makes it all the more likely they'll pursue any member of a controlled group to fund shortfalls.”
The “controlled group” is defined as parents and subs that are engaged in a trade or business and brother/sisters with a common parent. “If you have holding company X with a subsidiary A and subsidiary B, and a pension plan of subsidiary B gets taken over by the PBGC, the PBGC would view the parent or subsidiary A as liable,” says Lewis. The PBGC views a private equity fund as a trade or business, placing that fund in the chain of ownership that can be assessed for liability. To be viewed as part of the controlled group, the fund would need an ownership stake of 80 percent or higher.
As a result, Lewis explains that many buyout firms may consider spreading their stake across multiple funds or passing on the target altogether. “Funds targeting industries with frequent pension issues are already sensitive to the health of such programs,” he says. “Even beyond any action by the PBGC, pension funds rely on public market returns and if they're underperforming, a bidder may think twice about the investment.” Given the persistent instability of the US economy, pension liabilities may soon prove an equal hurdle on either side of the Atlantic.