Private equity sponsors investing in industries with union employees covered by multiemployer plans – i.e., pension plans sponsored by unions to which many different employers contribute – should pay special attention over the next several years to the potential liabilities under those plans. A recent report issued by Moody’s highlights the financial turmoil surrounding multi-employer plans caused by the economic downturn and other factors. While these plans are generally prevalent only in a narrow slice of industries of the old economy, private equity sponsors investing in these industries should be diligent in ascertaining the full range of effects that these plans could have upon potential targets. These effects, described in this article, include cash costs not fully reflected as liabilities or contingencies in a target’s balance sheet (or related foot-notes), credit downgrades and labor unrest.
 |
|
Jonathan Lewis |
Brief overview of multiemployer
plansMultiemployer plans (sometimes also referred to as Taft-Hartley plans) are plans formed and sponsored by unions and typically cover employees within a particular industry (such as the construction, trucking and hotel/casino industries). As part of the collective bargaining process, a group of employers agree to make contributions to these plans – a typical contribution formula would be a fixed dollar amount for each hour worked by a union employee covered by the plan. For technical reasons, even before the current economic downturn, these plans were often underfunded because the levels of plan benefits would be increased as the value of the plans’ assets increased.
|
|
|
Alicia McCarthy |
Still, notwithstanding the potential for a contributing employer to bear liability in connection with plan underfunding, these exposures are generally not required under GAAP to be reflected in any way on a contributing employer’s financial statements unless and to the extent actually paid, in which case they are run through the employer’s statement of cash flows. In that sense, from the perspective of a contributing employer’s financial statements, a multiemployer plan is like a 401(k) plan because the cash liability runs through the statement of cash flows, but no liability for underfunding appears on the balance sheet or in the footnotes to the financial statements.
The principal exception to that accounting treatment is if the contributing employer negotiates an exit to its future obligations to contribute to the plan (either in whole or in part). The liability recognized by the employer in this circumstance, known as “withdrawal liability,” is assessed by the plan based on a statutory formula and is typically payable in installments over a number of years. When a withdrawal liability is triggered, the liability would be includible both in the statement of cash flows and on the balance sheet.
Prior to the current economic downturn, the economic and non-economic costs of contributing to a multiemployer plan were often relatively stable and not disruptive of the normal operations of a contributing employer (except in the event of the employer’s withdrawal, which was rare and usually within the employer’s control). But despite the continuing accounting treatment of these exposures under GAAP described above, acquirers and ratings agencies are now focusing more closely on the potential liabilities under these plans in light of the economic downturn, demographic changes and legislative initiatives. In September 2009, Moody’s issued a report in which it catalogs the current funded status of multiemployer plans and the expected future pressures under these plans over the next several years. The Moody’s report says that, although widespread downgrades of contributing employers are not expected, it is possible that a contributing employer’s increased cash obligations under such plans (which Moody’s, unlike GAAP, treats as a debt-like adjustment to the employer’s financial statements) may increase the employer’s risk profile and be a factor in considering a downgrade of it.
Effect of the economic downturn and other events
Multiemployer plan risk is by no means new, but a number of events over the past few years have converged to increase this risk.
- • Economic downturn. The most important of these events is the economic downturn, which has exacerbated the already significant underfunding of many multiemployer plans. Data collected by Moody’s estimates that multiemployer plans were collectively 77 percent funded in 2007 and are likely to be 56 percent funded in 2008. (The precise underfunding will not be known until the plans’ 2008 annual informational returns become public.) In addition, bankruptcies have operated to reduce the number of contributing employers in industries covered by multiemployer plans. The result of these factors is a declining number of employers having the obligation to fund an increasing liability.
- • Change in union demographics. There have also been important changes in union demographics. New entrants in traditionally unionised fields are less likely to have unionised workforces. The Moody’s report cites as examples FedEx in transportation and WalMart in supermarkets. As a result, and in combination with population demographics generally, there are a fewer number of active employees in the plan supporting the benefit obligations to a greater number of retired workers in the plan who are living longer. Added to this mix is the potential withdrawal from plans by large, stable contributing employers (UPS being a prominent recent example).
- • Legislative initiatives. The Pension Protection Act of 2006 (PPA) categorised troubled multiemployer plans into “yellow zone” (badly underfunded) and “red zone” (very badly underfunded) plans. PPA requires that both yellow zone and red zone plans achieve specified funding targets within a 10-15 year period, a change from prior law. Red zone plans must also consider reducing benefits. The likely effect of these rules in most cases is an increase in plan contributions and a freeze or decrease in plan benefits. Subsequent legislation has softened the impact of these rules because of the economic downturn but not eliminated them entirely, and further legislation is possible. Interestingly, this legislation, which is intended to preserve the status quo for a plan until a market recovery, may have the effect of masking a plan’s true health to potential acquirors.
The combination of these factors seems to spell trouble for employers that contribute to multiemployer plans in the form of the direct cost of increased cash contributions and the indirect costs of decreased benefits, or both. Decreased benefits may create indirect costs as a result, for example, of increased unrest among the union population or by effectively requiring the employer to make up the lost benefits in some other way.
The Moody’s report offers as an example the Central States multiemployer plan, which covers the trucking industry. In December 2007, UPS, one of the largest contributors to the Central States plan, successfully negotiated to withdraw from the plan. This withdrawal required UPS to contribute roughly $6 billion to the plan, but, even after the contribution, the plan was estimated to be only 67 percent funded. Moody’s also estimates that, because of the drop in asset values in 2008, the plan’s current underfunding may be as much as $25 billion (corresponding to a 44 percent funding level). In mid-2009, another large contributing employer, YRC Worldwide, negotiated an 18 month funding holiday from the Central States plan because of financial distress. The Moody’s report points out that if YRC were to cease contributing to the plan altogether, the remaining contributing employers would be a fraction of the size of UPS and YRC and would be collectively responsible for funding the estimated $25 billion referred to above.
No (easy) way out
There is no easy way for an employer to control these obligations, for three reasons. First, withdrawal requires negotiating with the union. For example, UPS, which withdrew from the Central States plan in 2007, had been trying to do so for years, which reportedly contributed to a 15-day strike in 1997. Second, even where the union approves the withdrawal, the withdrawing employer must pay its allocable share of unfunded benefits in connection with the withdrawal upfront which, in the case of many of these plans, could be a substantial amount. For UPS, this amount was $6 billion. Finally, in order to prevent a race to the exits, Federal law also creates an additional type of withdrawal liability when substantially all employers withdraw from the plan at roughly the same time (whether or not in concert with each other). This liability – called “mass withdrawal liability” – essentially allocates the entire underfunding of the multiemployer plan to all employers who withdraw during a roughly two year period. Again, using UPS as an example, if a mass withdrawal were to occur under the Central States plan before 2010, UPS would be deemed to be part of the mass withdrawal and would be allocated its proportionate share of what Moody’s believes is likely a $25 billion underfunding – and this contribution would be in addition to the $6 billion UPS already has paid.
Effect on private equity
In any private equity deal in which the target contributes to a multiemployer plan, the potential plan liabilities should be a particular focus of diligence, despite the absence of any liability or contingency for these exposures on the target’s GAAP balance sheet. For the foreseeable future, it should be assumed that all multi-employer plans are at least “yellow zone” plans; this assumption is not likely to be too far off. More than a few will be “red zone” plans. These liabilities cannot easily be left behind with a seller or otherwise hedged against, and, while it may be possible to self insure these costs by modeling the possible cash contributions to the plan into one’s purchase price under a range of “normal” scenarios over the investment period, other risks associated with continuing plan contributions (e.g., the chances of successfully negotiating benefit changes, of labor unrest or of mass withdrawal) are industry risks and will not easily be quantifiable.
In all events, to be clear, (1) owning a strong player in an industry may not be enough to avoid these problems to the extent the strong player’s contributions increase due to the missed contributions of competitors who have withdrawn or gone bankrupt, and (2) private equity buyers should be modeling the possible effect of these contingent liabilities on a target’s credit ratings despite their absence from a target’s financial statement since, unlike under GAAP, these contributions obligation are treated as debt-like obligations by Moody’s, and they thus could, in the wrong circumstances, drag down the target’s credit rating.
Jonathan Lewis is a partner and Alicia McCarthy is counsel in the New York office of Debevoise & Plimpton. A version of this article originally appeared in the Fall issue of the Debevoise & Plimpton Private Equity Report.
If you do not receive this within five minutes, please try to sign in again. If the problem persists, please email: