The private equity industry is lobbying the UK Government intensively to change its amendments to the new Pensions Bill. The amendments, which were suddenly announced in April and could become law in April 2005, seek to stop companies from shirking their defined benefit (where the company agrees a fixed level of pension each year until death) pension scheme responsibilities and dumping them on the new Pension Protection Fund instead.
The amendments have severe ramifications for private equity houses, however. The proposed legislation removes their limited liability and, potentially, can make all their portfolio companies and even directors and their families, liable for any defined benefit scheme deficit. Buyout specialists say this could obliterate investment in UK companies with defined benefit schemes.
“The effect of the current draft on private equity investment would be shattering. Some private equity groups would cease to be viable the day this became law, as it would precipitate the bankruptcies of many of their portfolio companies. No one in their right mind would buy a company from groups with defined benefit schemes, which include most older and larger UK companies. These groups would become like leper colonies; no one will touch them,” says Jon Moulton, managing partner at Alchemy Partners.
Private equity firms could decide to invest elsewhere instead. Given that most of the UK’s larger and older corporate groups have defined benefit schemes’ according to the Government Actuary’s Department (GAD), in 2000 there were 29,400 UK defined benefit pension schemes, with 9.1 million members, this would be catastrophic for investment in the UK. “If the April amendments became law, private equity houses could start to invest only in companies where the group has never had a final salary scheme, which comprises very few UK companies indeed, or to stop investing in UK companies altogether. Private equity firms could opt to invest only in Continental Europe,” says Katie Banks, partner at Lovells.
Spiralling pensions problem
The UK’s spiralling pensions problem drove the Government to introduce this new Pensions Bill. Pension fund valuations have nose-dived in the past three years, due to the stock market slump and today’s ageing population, with rising longevity and falling birth rates. According to GAD’s 2002 figures, by 2050 a man aged 65 can expect to live 19 more years and a woman to live for 21.7 more years, compared to 12.1 years for a man and 15.3 years for a woman in 1960, while the population aged 65 and over as a percentage of those aged 15 to 64 has risen from 22.6% in 1975 to 24.4% in 2000, with 2025 projections at 32.8% and 2050 at 39.2%.
Specialists estimate that, as a result, most defined benefit schemes are now in deficit, threatening the future financial security of millions. According to Lane Clarke & Peacock (LCP), the total deficit under FRS17 accounting standards for defined benefit schemes of FTSE 100 companies stood at £42bn in July. Although this was down from £55bn in July 2003 due to increased company contributions and more favourable stock market conditions, longevity could add a further £20bn deficit for these companies’ balance sheets. In addition, under the new legislation, LCP states that the potential real cost to FTSE companies of walking away from their defined benefit schemes could be far higher, at over £125bn.
“Allowing a significant pension deficit to persist without a clear plan to address it should not be allowed. These deficits are a monstrosity; the company is effectively borrowing from its ex-employees without their permission and risks ruining them,” said Martin Taylor, chairman of the board of trustees for the WH Smith Pension fund.
The sheer size of some schemes relative to the value of the company is astounding. LCP reports that 10 companies had FRS17 deficits in excess of 25% of their market cap at the end of their 2003 accounting year, comprising BAE Systems, BA, BT, Cable & Wireless, GKN, ICI, Rolls-Royce Group, Royal & Sun Alliance, J Sainsbury and Whitbread. LCP estimates that the FTSE 100 index would have to increase to over 5,900, by over 35%, for the FRS17 deficits to be eliminated.
It was to help safeguard the financial future of employees whose companies cannot pay their pension deficits that the new Pensions Bill was conceived. The Bill, which was announced last June, with a first draft published in February, proposes a Pensions Protection Fund (PPF), backed up by a Pensions Regulator, which will focus on under-funding, fraud and mal-administration.
Shock amendments
However, on April 27, the Government announced some unexpected amendments to the February draft, to prevent the PPF from becoming a mass dumping ground for unscrupulous employers trying to avoid funding their deficit liabilities. The amendments proposed two extremely broad anti-avoidance, or “moral hazard” clauses. The first clause is designed to stop companies deliberately trying to avoid funding their final benefit pension schemes by passing the liability on to the PPF. Where the Regulator perceives that a company has acted to do this, or failed to act to prevent this, it has the power to make the company liable for the deficit. Crucially, the regulator can also make all other past or present associates of the company – even individuals such as company directors and their families, liable. This rule would be applied retrospectively to acts or failures to act after June 11, 2003.
The second moral hazard clause is focused on companies that did not necessarily try to avoid paying for their defined benefit pension schemes, but find themselves with a deficit nevertheless. Even if there was no wrong-doing, the regulator can force the company and any associates to provide financial support contributions.
In addition, the Government announced that the way in which a pension’s shortfall is calculated, for example, when a company withdraws from a final salary pension scheme in an acquisition situation, – will now be calculated on an annuity buyout basis, rather than today’s minimum funding requirement (MFR) basis. The buyout basis is far more draconian and much higher than the previous MFR and calculates the debt by reference to the full cost of buying an annuity policy to secure the members’ benefits. Thus the level of debt owed by a company that is sold off will increase substantially.
Major impact on PE
The broad wording of the amendments was greeted with horror and shock by the private equity community. While the changes to the MFR calculation are of great concern, making companies far more expensive to buy (unless the vendor agrees to a lower price) and impacting cash flows and leverage multiples, it was the anti-avoidance rules that really provoked an outcry in the private equity industry.
“The current moral hazard draft is draconian in the extreme and insanely wide. Any group company (past, present or future) can be served with an order requiring contributions to fix a deficit without limit of time or amount and without any test of ill faith. They are called moral hazard clauses but there are no tests of morals at all,” says Moulton of Alchemy.
Effectively, the April amendments mean private equity houses would swap their limited liability for unlimited liability on any shortfall in a defined benefit final salary pension scheme. “Private equity houses have always had to consider defined benefit pension deficits. But while before they only had to carve out contributions from the company’s cash flows and, if the deal went badly, they could put the company up for sale or into liquidation, now, they will have to find the funds to settle the deficit. They can no longer buy and sell a business without dealing with the deficit as a proper liability,” says Banks of Lovells.
It is, above all, the potential liability of individual directors and their families that has caused the greatest uproar. “Anyone even remotely associated with the acquired company can be served directions to contribute to its final salary pension fund deficit. The legislation is so broad that it could hypothetically involve the directors’ childrens’ nanny’s husband. So if a company in a private equity firm’s portfolio cannot afford its pension scheme, then the regulator could force other companies in the private equity firm’s portfolio, as well as directors and family of the private equity firm, to be liable for the shortfall,” says Banks.
In addition, the definition of “an act or deliberate failure to act” in relation to a debt to a scheme is far from clear. “The regulator could decide that you acted or failed to act to prevent a debt arising or being recovered even if that was not your intention, as a failure to act could include paying too large a dividend, or selling off assets and using the proceeds for other means than covering the pension deficit,” says Banks.
Law of unintended consequences
The immediate effects of the April amendments have been to stall buyouts of companies with defined benefit schemes. “Until this Bill is completed, we are not doing deals with significant defined benefit schemes,” says Moulton.
If the legislation went through under the current draft, both corporate and private equity acquisitions of firms with these schemes could be annihilated. “If there is a big defined benefit scheme somewhere in a group, the group members may have to live together for ever in a sort of corporate equivalent of a herpes dating club,” says Moulton.
Funds containing one portfolio company with a large deficit could be wiped out, which would make future fund raising extremely difficult. Foreign investors especially are likely to be put off investing in the UK. “This could make it very hard to raise senior debt to support the buyout and also to raise any future private equity funds,” says Tim Cox, partner at Linklaters and chairman of the Association of Pension Lawyers.
Pensions due diligence would become a nightmare. Private equity firms would have to pay far higher fees for due diligence and pensions and actuarial advice, with extremely thorough and retrospective checks on all companies in their portfolios as well. “There would be expensive upfront costs such as increased fees for pension due diligence. Insurance against these pension liabilities would be too complicated and far too expensive to be realistic. Effectively, you would be insuring against your own failure to make a success of the business,” says Cox.
Deals would take far longer to push through and post buyout restructurings would become difficult, given the danger of the regulator deeming the restructuring an act to avoid paying for the pension deficit.
Temporary victory
Following intensive BVCA lobbying to the Government to change the amendments, the moral hazard clauses were brought for further discussion before the House of Lords. Debates continued until Parliament broke for summer recess, although the industry remains in talks with the Department for Work and Pensions (DWP.) The matter will be discussed again in Parliament when it reconvenes on September 6, with a view to having assent for the Bill by November.
The lobbyists have already made some headway, as the Government has agreed to revisit each clause to try and alleviate the unintended impact on M&A activity and investment in the UK. “We are in constructive discussions with the DWP and are hoping for a number of changes to the moral hazard clauses, including definition about which associates exactly would be liable, time-limits to the liability and retractions of both individual liability and the retrospective nature of the liability,” said a BVCA spokesperson.
In July, the Government also announced a clearance procedure, whereby a firm seeking to restructure or a private equity firm planning a buyout could apply to the regulator and gain assurance they will not fall foul of the moral hazards clauses. Yet as the threat of the regulator deciding a scheme is insufficiently funded and serving a financial support direction to anyone connected with the employer remains, there is still a great cause for concern.
Most lawyers expect the Government to make some more concessions in September, but remain very uncertain whether these will be sufficient for private equity firms. “The Government is likely to modify some of the offending provisions, for example, to clarify that liability would only apply to those involved in deliberate skulduggery. But it is not yet clear whether all the private equity industry’s concerns will be addressed,” says Cox of Linklaters.
Given the new annuity buyouts basis calculation of deficit debt, even if some of the amendments are watered down, in future, buying companies with defined benefit schemes in the future will be more expensive for private equity firms.
Moreover, even if the individual liability moral hazard clauses are withdrawn, lawyers doubt very much that liability of portfolio companies will also be lifted. Private equity houses will have to accept the loss of their limited liability if they choose to invest in companies with defined benefit schemes.
“The buyer and seller are likely to have to share the hit. The price of companies with defined benefit pension deficits will go down, but private equity houses will also have to accept more liability. Following our latest meeting with the DWP in early August, it seems very likely that all companies in a private equity portfolio will be liable for any one firm’s struggling scheme. So limited liability will disappear,” says Banks.
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