Underfunded defined-benefit pension plans are a relatively recent phenomenon. Increasing life expectancies, equity market declines during 2000-02 and a long-term decline in interest rates have combined to leave many pension plans short of the assets they need to meet their obligations. While the situation has improved somewhat in the past two years, the pension plans of many leading companies remain underfunded.
Private equity firms have been affected by the changing pension landscape. In the past, pension concerns were rarely paid much attention, but investors who fail to properly evaluate the pension plan at a target company run the risk of overpaying or having to inject additional cash, either of which can derail a deal’s economic viability.
Concern over pensions has already disrupted or altered several major deals, especially in the UK.
The financial statements – especially the balance sheet and the income statement – are the obvious starting point, although the possibility of hidden, off-balance sheet pension data needs to be addressed. The data driving the profit and loss statement and how the P&L should be adjusted going forward, are the most important.
Current and projected employer contributions to the plan (and employee contributions in hybrid plans) need to be evaluated.
Analysis of these data will give a sense of a plan’s funding. With appropriate actuarial valuations, cash flows going forward can be calculated and fed into the earnings projections in the acquirer’s valuation model.
Typically, business valuations are a multiple of earnings or EBITDA. If there is a significant unfunded position, the acquirer can separate the pension data from EBITDA and assess the timing of future funding commitments. There are other options, including treating the unfunded position as an upfront debt adjustment, taking care not to double-count the impact of the deficit on the ongoing pension costs included in EBITDA.
Once the liability situation is understood, the plan’s funding position can be determined. This data needs to be rolled forward so as to provide better understanding of where the plan will stand at the closing. Analysis should reflect estimates of accrued liabilities, current and future contributions and projected liabilities, all under various scenarios (such as termination of the defined-benefit plan and conversion to hybrid status).
The basics of pension fund due diligence are straightforward. However, the shifting climate in pensions has caused a number of idiosyncrasies to emerge – situations that are unique to pension management. In order to improve their due diligence, private equity investors need to understand the inner workings of retirement planning, and here are seven things they need to know.
Carve-outs add complexity
Carve-outs of discrete divisions are more complex than whole acquisitions because the pension plan typically is divided into pieces, potentially leaving uncertainty about liabilities and available assets.
In a carve-out, the acquirer needs to understand its exposure and the cash commitment needed to meet the plan’s ongoing obligations. Among the things to know is whether the deal includes the division’s pension liabilities; how the cost of the overall company plan liability has historically been allocated to the division being sold; how the assets are being transferred; and, whether companywide actuarial assumptions are appropriate for the division being acquired given their demographic profile.
Pension liabilities are more important than assets
Understanding a pension plan’s liabilities is even more important than understanding its assets: While it is always possible to improve asset performance, an acquirer can do much less about altering the liability side of the equation. Crucial liability-side information includes data about the employees covered under the pension, especially their demographic profile. Companies typically review these actuarial evaluations annually, and generate relevant disclosures and discussion of assumptions. These data are vital: While actuarial projections historically have notoriously underestimated remaining life, there have been significant improvements during the past decade, especially in the UK, and actuaries today can better estimate future liabilities.
In evaluating liability projections, acquirers need to remember that seller projections of employee behavior may be unrealistic. For example, turnover may be lower than anticipated, with more workers becoming vested in the plan than expected. Retirement rates may be different than projected, which could result in workers retiring earlier than expected. Some plans have special termination benefits which need to be factored into decisions about head-count reduction.
Actuarial assumptions drive decisions
Actuarial assumptions, especially mortality assumptions, are important:
In the UK, full life expectancy has been rising one year per decade on average, and this extends the term of each pension obligation. The resulting impact is significant: A one-year increase in UK life expectancy could increase the overall cost of the nation’s private sector pensions by $60 billion to $80 billion (£30 billion to £40 billion).
In addition to actuarial assumptions, acquirers need to understand the financial assumptions, including timeframes, inflation, discount rate, interest rates (which sometimes are estimated on the high side), projected rates of return on plan assets and any cost-ofliving adjustments (which are customary in Europe).
Pension assets are increasingly difficult to value
Following concerns over inflated asset values in pension plans during the 1990s, regulators have been shifting from the conventional actuarial approach, with its use of smoothing techniques, to a more finance-based method. This shift stems in part from new regulations, such as IAS19 in the UK and FAS158 in the US, which require that assets be marked to market; in the past, actuaries sometimes approved higher values.
In spite of this shift, many pension assets are difficult to value because of increased use of alternative investments. Many of these involve illiquid or thinly-traded assets or investments in opaque partnerships that are difficult to properly value. In addition, a large, recent shift of asset type in a plan may indicate the administrators’ belief that they need to act aggressively to close a gap between assets and projected liabilities.
Pension plan trustees have growing power
Pension plan administrators and trustees have growing powers, particularly in the UK where the Pensions Act gives them considerable responsibilities and powers in cases such as an acquisition or restructuring of debt. The trustees have a great deal of authority to determine how a plan is funded and at what level, and in the past have required significant cash injections at closing or other steps that have affected a proposed deal’s economics. In the US, the Pension Protection Act mandates that trustees of plans with significant deficits improve the plans’ funded position.
Act globally, think locally
Private equity firms that invest in companies worldwide need to understand local markets, demographics, valuation requirements, accounting differences and other factors that can determine whether a transaction makes sense. Examples of local provisions that can affect deal dynamics include German Altersteilzeit – early retirement agreements – termination indemnities in France and Italy and length of service awards (jubilee payments) in a number of nations.
And, even with growing convergence between US GAAP and international accounting standards, enough differences remain that misunderstandings can occur in global transactions.
Options exist
Some pension plans are so deeply underwater that it may make sense not to do the deal. However, there are a number of solutions to underfunded pensions beyond walking away from a deal, and acquirers need to understand their full range of options and what makes the most sense for their particular circumstances.
Buyers can offer price adjustments, seek warranties or indemnities from sellers, insert protective language into the agreements or look at alternative deal structures to help the investment be successful.
If a buyer does not want to treat the unfunded plan as a continuing liability, it can request that the seller retain the pension responsibility in exchange for an increase in the purchase price or an agreement to provide future service funding.
In addition, buyers can explore post-transaction measures such as freezing a plan’s enrollment or future benefit accrual; moving from a defined-benefit plan to a defined-contribution plan; using debt financing to fully fund a plan; amending covenants to share risk with plan members; employing liability-driven investment to match projected liabilities with investment goals and strategies; turbo-charging returns through alternative investments; and shifting risk to the capital markets by transferring liabilities to an insurer or other third party.
Regardless of what a private equity firm decides to do, it is essential to have a strong team providing advice and support. The team, whether in-house or contracted, should have broad experience to assist the buyer in evaluating the pension liability and their options. Skilled pension actuaries, specialists in asset valuation, economists and other professionals independent of the seller provide invaluable guidance and counsel, especially during fast-moving transactions when data need to be evaluated on the fly.
The private equity business is in its golden age, a period of unparalleled growth and prosperity that is helping to reshape the global economy and enable it to better meet the challenges of the future.
However, private equity investment is never without risk: That is what justifies its returns. But, by conducting proper due diligence on pension and other retirement programs, a private equity firm’s general partners can avoid undue risk and provide superior returns for themselves and their limited partners.
Steve Rimmer also contributed to this article
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