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Pension deficit heats up oven sale

PENSION schemes can often be a deal-breaker in M&A. Since the advent of the Pensions Act 2004 and the birth of the UK Pensions Regulator, defined benefit (DB) pension schemes have become increasingly important stakeholders in corporate transactions. But in the case of the planned £129m sale of Aga, addressing the pension deficit was a key component of the deal.

In July, Aga’s board approved an offer by Middleby Corporation, which included guarantees for the oven-maker’s schemes that have an £84m deficit and almost £1bn in liabilities. Attempts to plug the deficit had prevented it from promoting and developing its products, or paying a dividend to shareholders for the past three years.

The deal gives Aga more clout and better access to international distribution networks, but also includes a number of measures to address the deficit, agreed with trustees of the Aga Rangemaster Group (ARG) Pension Scheme. Trustees, as custodians of the pension scheme, have their own fiduciary duties to meet.

Alex Hutton-Mills, managing director of Lincoln Pensions (which provided advisory services to Aga’s pension trustees), notes that the Aga transaction reminds finance directors that early engagement with the trustees and their advisers can be critical to the success of a potential transaction.

“The parties negotiated an appropriate package that provides the buyer with the strategic benefits of the Aga premium-brand business; it also has clarity on triennial valuations [of the scheme] over a period and the trustees have the support of the existing Aga business and access to broader Middleby group through the contractual arrangements agreed,” he says.

Conditions of the deal include contributions, funded by Middleby, of £10m a year in 2015 and 2016, and contributions from Aga of up to £2.5m in each of the following six years. The agreement also includes two guarantees to be given to the ARG scheme by Middleby Marshall Inc.

The first is an “unconditional” guarantee of Aga’s obligations to the scheme subject to a cap of £60m and the second is a conditional guarantee with a starting cap of £95m. The second guarantee is conditional on the trustees abiding by funding and investment strategies agreed with Middleby, while the cap on it will vary – depending on dividends paid out and recovery contributions made.

Cleary, it is important to consider the scheme funding and technical provisions currently in place very carefully. By addressing the trustees as early as possible in the process, the buyer can ensure they are not impeding the overall transaction timetable or likely to make demands that could bring the whole purchase to a grinding halt.

Hutton-Mills adds that while the relative size of the pension scheme to the business is an important starting point when considering if it is worth purchasing a company with a sizeable defined benefit scheme, it is also important to consider the scheme funding and technical provisions currently in place very carefully.

Employer covenant

The balance in negotiations is changing, however. Steve Kirkpatrick, director in PwC’s pension deals team, says he has seen a real change in the way sellers are treating pension plans in transactions.

“Buyers face considerable uncertainty about the way that the pension plan will react to the deal, particularly when the transaction is financed through additional secured debt. In the past, this uncertainty has often led buyers to take a cautious approach when ‘pricing in’ the pension plan reaction to the deal – reducing value for the seller,” he explains.

“Sellers have become much smarter about this in the past couple of years and want to provide the buyer with much more certainty, both to increase the pool of potential suitors and to avoid conservative pricing approaches. In order to give this certainty, we are seeing sellers increasingly approaching their trustees before the sale and pre-banking agreements with the pension plan – which the buyer can then step into. The text-book example of this would be the seller agreeing a range of pension contributions with the plan dependant on the level of post-transaction leverage.”

Lynda Whitney, partner at Aon Hewitt, agrees that the pension schemes trustees may be heavily involved during negotiations where there is a funding agreement in place, as seen at Aga. She believes that it is important that FDs are sure of the potential figures they could be looking at before engaging with trustees. An accounting figure is what the deal will look like to investors but may underestimate cashflow commitments.

A scheme funding or technical provisions figure outlines what the demands are in the short term and what has been agreed. A buyout figure is likely to be the largest as it is the figure representing the long-term demand on the employer.

If an entire business is being sold, the change in ownership may have an impact on the strength of the “corporate covenant” – ie, the financial ability of the business to support the DB obligations in light of its other financial obligations. This, in turn, may change the scheme funding or technical provisions figures.

“It is worth remembering that current funding deals are based on the covenant with the employer so the scheme funding figure can be changed based on the trustees’ view of the new employer,” explains Whitney.

Rebecca Colley, chartered financial planner and operations director at Informed Financial Planning, notes that a DB pension is an unquantified liability and that the ongoing management of such risk provides a distraction from the everyday business that is not usually understood.

“Future increases to mortality rates, bond yields or changed regulation can greatly alter such liabilities,” she says.

Key things for buyers to consider
Steve Kirkpatrick, director in PwC’s pension deals team
I think that there are three key things for a buyer to think about when there is a significant pension deficit in the target company.

Firstly, do I understand the financial risk I am taking on? This question is made complicated by the way pension accounting rules work, meaning the liability reflected in the target company’s balance sheet is unlikely to be a true reflection of the future cash costs of the pension plan. Buyers should take advice on what the true economic obligations of the plan are and also how these costs may change if future stock market performance, interest rates, inflation and life expectancy rates change.

Secondly, how will the pension plan react to the transaction itself? If the transaction is considered to have a negative impact on the position of the pension plan as a creditor, the plan can demand immediate cash contributions, faster repayment plans or other forms of security. The pension plan has powers to protect its position through control of investment and financing strategy and is protected by the Pension Regulator which also has strong powers to protect pensioners when transactions are considered detrimental.
Finally, are there any upside opportunities in pensions? For the right buyer, there can be opportunities to unlock value by providing innovative forms of security to the pension plan. You can see from the disclosed documents on the Aga sale to Middlebury that some careful thought was put into constructing guarantee packages that worked for all parties.
One area that purchasers should think carefully about is conditional guarantees – where the trustees agree to abide by certain investment and funding strategies. These ideas are relatively new phenomena in pensions but offer a potentially useful way to bridge the gap between the need for the pension plan to have additional security and the desire of the company to keep some control on areas like funding and investment strategy.

Takeover targets?

In a previous interview with Financial Director, Tony Chanmugam, the chief financial officer of BT, suggested somewhat wryly that BT’s pension deficit had protected the business from takeover during the midst of its dramatic revival. The size of the liability had just made BT too unpalatable.

As Kirkpatrick notes, DB scheme deficits can make a company a takeover target, but not often.

“I have seen transactions on listed companies where the stock trades infrequently (and therefore the share price is pretty constant) and purchasers have taken the view that the discount inherent in the market price for pensions is conservative based on current markets or their own view of future market movements. More often, though, I think the reality is that large pension obligations will put purchasers off,” he says.

If the transaction is structured as a share sale, post-transaction, the sellers will no longer have responsibility for the scheme. Therefore, contemplating a merger can seem like a good way out for companies struggling with DB scheme deficits.

“Sponsors with significant pension schemes can often see corporate activity hampered as a result of the pension scheme, which will include reducing or halting dividends and reduced investment in the business,” says Kirkpatrick.

“As well as all the usual synergies that can be created from a larger group, companies can use their balance sheet to provide security to the pension plan. This allows the trustees of the pension plan to take a more relaxed position on the funding and investment strategy of the pension plan, which in turn will reduce the constraints on corporate activity.”

Colley notes: “It has been shown that a poorly managed defined benefit scheme can provide opportunities to reduce liabilities by between 10% and 20% – a significant reduction which provides room to increase a company’s share price.” 

 

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