Pension funding carries more weight in U.K. deals

The importance of pension schemes in private equity deals involving U.K. companies has risen in recent months as economic problems have hurt pensions’ funded status and made valuing companies’ cash flows more difficult

“This has been a factor for some time, but (it is) probably intensifying with the difficulty of arranging buyouts of the pension liabilities, and the increased deficits brought about by the market fall,” said Kevin J. Pakenham, London-based managing director at Jefferies Putnam Lovell.

In private equity deals, trustee concerns usually center on a change in the creditworthiness of the company, since well-rated corporate sponsors tend to be replaced by debt-loaded entities set up by the private equity firms.

Those concerns were behind two failed 2007 takeover bids for London-based grocer J Sainsbury PLC — the first by a consortium of private equity firms, the second by a fund owned by the Qatar Investment Authority.

Experts say longevity risk and other pension issues related to funded status are of major importance in the highly regulated U.K., where pension trustees have halted private equity deals they felt would weaken their ability to keep the plan well funded and where the U.K. government can require contributions by the acquirer.

In a recent survey of U.K. private equity managers by Punter Southall Transaction Services, London, longevity risk — or more specifically the risk that mortality assumptions for calculating pension liabilities might change between the time a manager buys and sells a company — led the list of risk concerns. Respondents were more concerned with longevity risk than future regulatory/legislative changes or future investment risk.

Chris Parlour, senior consultant at Punter Southall Transaction Services and a co-author of the report, said he wasn’t surprised by concerns about longevity risk. “We’ve talked a lot about it in the past three or four years,” he said. “It affects every (company’s) pension scheme.”

Experts view pension concerns in the context of a number of trends that began years before the massive stock slides of the past few months.

The combination of equity market declines, the steady increase in concern over longevity risk and ever-increasing pension regulations “have raised (pension concerns) to a new level of immediacy,” said Charles Cowling, managing director at corporate pension consultant Pension Capital Strategies, London.

Private equity houses have paid close attention to pensions issues since at least 2003, when U.K. regulations changed. Under the new rules, if a company wanted to wind up its pensions scheme, it must provide funding for all buyout costs.

Previously a company needed only to fund the plan to 100% of liabilities; participants would see a benefits reduction if their scheme was wound up because buyout costs tend to be about 30% greater than total liabilities. In 2004, the government transformed the Occupational Pensions Regulatory Authority into the Pensions Regulator, giving the new body increased powers to force companies to make contributions.

Longevity risk also has been a growing concern. Actuaries use myriad mortality assumptions in calculating pension liabilities, and mortality tables are based on recent experience, not projections on future life spans, meaning those assumptions might very well change over time.

“Longevity is the one thing that nobody really knows what the answer is, and no one can really hedge,” said Brian Magnus, managing director and European co-head of Morgan Stanley Private Equity in London. He said uncertainty about mortality assumptions will prevent longevity risk hedging markets from being developed. “Until there’s an agreed standard, there’s nothing to hedge against.”

In recent months, two things have happened, said Mr. Cowling. Market declines have reduced most pension assets, while the increasingly uncertain economic environment is putting pressure on company cash flows. Meanwhile, with lower funding levels and weaker company balance sheets, pension liabilities will have an amplified effect on balance sheets.

“People (in private equity) are being more careful because company cash flows are under more pressure than before,” said Tom Leader, investment partner at Nova Capital Management Ltd., London, which invests in portfolio deals and had €300 million ($380 million) in assets under management as of Sept. 30

“Anything that affects the finances of the pension scheme … has a direct impact on the (company) owner,” Mr. Cowling said.

Rosalind J. Connor, a London partner in law firm Jones Day’s employee benefits group, said if a private equity manager owns two-thirds of a company — or has any “specific powers of management” in a business, such as the ability to appoint board members — it could be forced by the Pensions Regulator to provide funding for the pension scheme.

The concern that private equity firms will be seen as having deep pockets is “preying on the minds of people in the private equity sector,” she said. “It frightens a lot of private equity investors away.”

“The key problem … is that you’re trying to understand how much more longevity can continue to increase,” Mr. Cowling said. “That has a material impact.”

Nova’s Mr. Leader said longevity risk is a “key driver” of pension liabilities. “It’s something we look at incredibly closely,” down to the specific characteristics of a company’s scheme, he said.

“We don’t have the skills in-house (to look at the specific characteristics) but we know who to talk to,” Mr. Leader added. There are tailor-made solutions for different situations, he said.

The concern for private equity managers is that the assumptions they use to value liabilities at the beginning of a deal won’t be the assumptions needed when it comes time to sell the company. With longevity increasing about two years every decade, that factor alone could wipe out a deal’s profitability, especially in tough times.

“You’ve got to be careful,” Mr. Leader said.

Pension liabilities are also putting the pinch on private equity because of the costs associated with buyouts. Punter Southall found that just one in four private equity firms were interested in paying the going rate for a selling the pension liabilities.

For some companies, asset declines have created or exacerbated situations where a company’s pension liabilities might equal or even dwarf the size of the company’s market capitalization. That sends most private equity firms fleeing, experts said.

With companies “where the pension scheme is bigger than the size of the equity market cap, you’ll be causing a private equity firm to take a second look,” Mr. Cowling said. “It significantly changes the dynamics and makes it harder for a deal to be put on the table, let alone be done.”

But these problems don’t necessarily make buyouts of firms with pension funding issues impossible. “It is definitely the case that people fear pensions,” Mr. Leader said. “Many firms steer clear of companies with large pension schemes. That creates an opportunity for those people who are maybe not so fearful … and have a good plan for managing pension assets and liabilities.”

When acquiring such a company, a manager could use pension liability as leverage. “That’s equal to your leverage that you would have gotten from HSBC,” he said. There is less competition for those companies, “but you’ve got to go into these deals with your eyes wide open,” he said.

The catch is that liabilities need to be judged the same way at both purchase and sale. That’s typically the case when one private equity house sells to another, according to results of the Punter Southall survey. However, some private equity players expect to gain in transactions by pricing liabilities more conservatively at purchase than at sale. Also, public markets value liabilities differently, about 10% below accepted accounting valuations, the survey found.