Pension pain

In a move that drove home the vulnerability of private equity sponsors to the Pensions Act 2004, the UK Pensions Regulator has reportedly forced Duke Street Capital to fund a pension scheme deficit at a portfolio company it sold more than a year ago. It is the first time the pension authority has forced a retroactive payment.

Duke Street had to call in around £8 million from its investors to fill a pension deficit at retailer Focus DIY, which it sold to Cerberus Capital Management in June 2007. The company had struggled badly, and Duke Street received just £1 ($1.77) for its equity holdings. Cerberus agreed to pay off the company's £174 million of debt and pay £40 million to its bondholders.

According to reports, the regulator was called in to examine the sale of Focus Wickes, an add-on acquisition for Focus DIY that Duke Street bought in 2000. During its ownership of Wickes, Duke Street purchased 40 stores from DIY for Wickes. When Wickes was sold to Travis Perkins at a profit in 2005, no proceeds from the sale were put into the pension scheme, although the sale arguably left DIY weakened.

“The attractiveness of assets that are tied to pension funds may well have been diminished by the Pension Regulator's increased powers and the exercise thereof.”

By law, the Pensions Regulator has 12 months from the date at which sponsorship of a scheme changes hands to seek restitution from the previous owner. Duke Street chose not to seek a clearance notice from the regulator at the time of the sale of Focus DIY.

The Pensions Regulator has powers to look back for six years from the date it determines to impose a contribution notice. However, it cannot look back at acts or failures to act before April 27, 2004. When issuing financial support directions, the Pensions Regulator has no statutory restriction on how far back it can look at how an associated investor has funded a scheme and its employer and the returns extracted by investors.

The regulator was granted additional powers to pursue connected or associated parties this summer, a move that industry groups such as the British Private Equity and Venture Capital Association have protested.

“…these amendments would give the Pensions Regulator sweeping new powers which are so ill-defined that we fear their effect will be to kill off takeovers and investment in businesses with defined pension schemes,” BVCA chief executive Simon Walker wrote in the Financial Times.

Darren Mason, partner and head of pensions advisory within Grant Thornton's restructuring practice, said the action would be a “wake up call” for the private equity industry.

“The Pensions Regulator is not only able to look back at acts or failure to act since April 2004 but also examine what returns an investor has received and how an employer has been funded prior to that date,” Mason said in a statement. “The attractiveness of assets that are tied to pension funds may well have been diminished by the Pension Regulator's increased powers and the exercise thereof. Private equity firms and other organizations that tend to buy and sell businesses on a regular basis need to make sure that proper provision is made for pension liabilities.”

The Duke Street decision does not bode well for UK firms with exposure to large defined benefit pension schemes, including those at Terra Firma-owned EMI and Kohlberg Kravis Robertsowned Alliance Boots. Earlier this year EMI's pension trustees called on the regulator to intervene in a dispute with Terra Firma over a difference of more than £120 million between conflicting calculations of the fund's pension deficit.

The Pensions Regulator saw a 43 percent decrease in enquiries during the last financial year, from 874 in 2006-2007 to 494 in 2007-2008. At the same time, the number of M&A deals in the UK rose by 6 percent, according to data from Thomson Reuters. The decrease is likely a sign that firms are avoiding the regulator for fear of being forced to contribute to the pension schemes of their targets.