At the start of this year it became public knowledge that Ed Truell, co-founder of Duke Street Capital, would step back from his role there as chairman, instead taking on the title of partner and focusing on a new business line to be known as Duke Street Capital Structured Solutions. Not much more has been said on the subject other than that Duke Street Capital Structured Solutions would focus on financial strategies, notably around long-term pension provision. Although it’s likely that fundraising is obviously well advanced for this project, given that Truell will begin briefing the market on his project “soon”, according to his advisers.
Truell, who has already successfully built and sold another business, Duke Street Capital Debt Management, which created a number of collateralised debt obligation funds, has a track record that leaves the private equity and pensions industries expectant that Duke Street Capital Structured Solutions will be of some substance. However, Mark Wood pipped Truell to the post in April. Wood, ex-head of Prudential’s UK life assurance operations, announced a £500m fundraising for his new vehicle Paternoster Ltd, which will acquire defined benefit pension schemes from UK companies.
Since April though, Wood and Paternoster have been silent, a situation forced by a pending Financial Services Authority regulatory approval. Once this is achieved, expected sometime this summer, deals are likely both to happen and be discussed in the public domain.
report The “Crisis” in Defined Benefit Corporate Pension Liabilities: Current Solutions and Future Prospects, produced by Prof Clark and Dr Monk of the University of Oxford earlier this year, notes that the issue of defined benefit pension fund deficits is causing some companies (referred to as “plan sponsors”) financial uncertainty. They say: “Plan sponsors, keen to avoid diverted cash flows and balance sheet volatility are looking towards the bulk annuity market and insurance companies as a possible solution to their problems. The bulk annuity market is a unique type of outsourcing; companies pay insurers a premium for taking their pension assets and liabilities and removed the latent defined benefit pension risks from the plan sponsor. However, at present, this costly solution is only available to plans that have reached full funding.”
At present the bulk annuity market is a duopoly of Prudential and Legal & General writing almost all of the business, but at great cost apparently given that the UK Office of Fair Trading investigated the provision of bulk annuities last year after complaints of unfair pricing were lodged. The theory goes that if supply of bulk annuities buyers increases, prices will reduce to levels where more deals actually get done. With Truell (Duke Street Capital Structured Solutions) and Wood (Paternoster) about to launch on the market, this theory will soon be put to the test. Individuals set to join them, according to the report, include Warren Buffet, Isabel Hudson and Hugh Osmond, as well as Aviva, Aegon and “numerous investment banks”. These new players aim to make a profit by doing a better job than pension funds at managing the intersection between assets and liabilities.
What types of deals they will be allowed to do, however, remains to be seen. According to Prof Clark and Dr Monk, “In order for bulk annuities to have widespread appeal, supportive regulation, which eases capital requirements for firms underwriting the business, and clarifies the legality of the transactions, is required.”
The report goes on to say: “Though expensive, [bulk annuities] are a one-time charge that could eliminate the sponsor’s risks. As such, via bulk buyouts, traditional defined benefit liabilities could be sold off and new, more sustainable plans constructed. Ideally, this service would be offered to funded and unfunded plans (via pay down periods over a set number of years).” Given that the existing bulk annuity market is so uncompetitive, it would be the logical step to assume that new entrants will in the first instance stick to the easier fully funded transactions where premium pricing can be knocked away at and good deals still be done, before moving into the more challenging territory of under funded schemes, assuming supportive regulation is put in place to facilitate such a move.
Private equity firms, as well as every other company facing pension defined benefit fund shortfalls, will be watching this space with interest. According to a report in April from Grant Thornton Corporate Finance, which surveyed 100 mid market private equity firms typically investing in deals between £3m and £200m in value, only 37% of those surveyed completed an investment with a company that had a defined benefit deficit. But in 2004, the same survey found that all respondents had invested in a company with a defined benefit deficit over the course of the year.
This change in mood was highlighted recently when WH Smith, the subject of a proposed public-to-private buyout in 2004 that notoriously fell flat when newly empowered pension trustees (that same year they were made unsecured creditors of a company by the UK government) effectively made the deal too unattractive and difficult for Permira to continue with, was again the talk of private equity bid speculation thanks to its substantial pension fund deficit shrinking on the back of rising equity markets this year.
Whether existing private equity firms with defined benefit pension scheme deficits housed among their portfolio of investee companies will get to benefit from these new entrants to the market offering to take those liabilities away, remains to be seen. It might certainly be a route for some to facilitate an otherwise difficult exit. According to the mid market private equity firms that Grant Thornton surveyed, their exposure, however, to such shortfalls is relatively limited. When asked what proportion of their portfolio had significant pension deficits, 58% claimed to have no deficits at all at the end of Q1 this year compared to 48% saying the same thing in Q1 2005 (although it’s well to remember that rising equity markets and higher bond yields during Q1 this year have had a dramatic impact on pension fund deficits, cutting them overall by as much as one-third, according to some estimates) However, 92% in Q1 this year claimed to have significant pension shortfalls in 30% or less of their portfolio.
Luckily for those housing a defined benefit deficit the risk-based levy payable to the Pension Protection Fund is to be calculated as of March 31 this year, when equity markets were on the rise and, according to an estimate from Stephen Yeo, a senior consultant at Watson Wyatt, the overall final salary (defined benefits) pension deficits were calculated to have fallen from £64bn at the beginning of March this year to £44bn by the end of the month. This calculation was for deficits faced by FTSE100 companies. The payments to be made into the Pension Protection Fund are based on deficits as of March 31 each year in conjunction with an insolvency score, devised by Dun & Bradstreet, which is supposed to indicate the likelihood of the insolvency of the sponsoring employer. The payment is made up of a standard levy, relative to size etc, and a risk-assessed based levy.
Now that equity markets have suffered a month or two of falls and jitters, it just goes to show how volatile the pension situation can be. And as such it’s easy to see why the likes of Wood and Truell see a great market opportunity in creating certainty for any company with a defined benefit scheme, unfunded or not, and in private equity terms possibly being able to remove a significant hurdle to either investments or exits happening within portfolios.
Pension Protection Fund:
The Pensions Act 2004 sets out the conditions that must be met for the Pension Protection Fund to assume responsibility for a scheme. Key criteria follow:
a) the scheme must be a scheme, which is eligible for the Pension Protection Fund
b) the scheme must not have commenced wind up before 6 April 2005
c) an insolvency event must have occurred in relation to the scheme’s employer, which is a qualifying insolvency event
d) there must be no chance that the scheme can be rescued and
e) there must be insufficient assets in the scheme to secure benefits on wind up that are at least equal to the compensation that the Pension Protection Fund would pay if it assumed responsibility for the scheme.
For details of eligible schemes go to http://www.pensionprotectionfund.org.uk/index/who-is-eligible/eligible-schemes.htm
Source: Pension Protection Fund