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The trm Report - November 2006 Since the requirement for trustees to consider the covenant came into being last year, a variety of service providers have emerged that aim to help trustees in this area. The two types of service broadly fall into two camps – those based on credit ratings methodology and those that might be termed corporate advisory services. The latter are largely provided by corporate recovery accountants although there are a few providers staffed by ex-investment bankers that provide a similar service. The two types of service are often viewed as competing with each other. However, the reality is that they provide quite different services for trustees, and far from being mutually exclusive, they might actually be complimentary. A greater appreciation of the two types of service might enable genuinely joined-up covenant management strategies to be developed. The following is suggested A starting point The first step in any risk management process is a measurement of that risk, in this case an assessment of the strength of the sponsor’s covenant. The covenant assessment is vital as it will provide a framework for the rest of the process and so it is important that this assessment is made objectively. Independent covenant assessments can be provided by experts in assessing companies’ risk of failure, such as rating agencies. Nearly all funding plans will rely on some future contributions from the sponsor. As creditors of the sponsor, it is crucial for trustees to understand the likelihood that the sponsor will continue to be able to make those contributions. A covenant assessment should therefore include some quantification of the risk the sponsor will be unable to meet its obligations over time. For example, a covenant assessment from a rating agency will give an indication of the risk of the sponsor failing over a number of years - 2% risk over 5 years, 5% risk over ten years, and so on. By quantifying risk in this way, trustees are able to set objectives and benchmarks which can then provide a framework for their covenant management exercise. For example, if a sponsor has a 5% risk of failure after 10 years and the trustees accept this level of risk for their funding objectives, the trustees’ aim would be to remove any deficits over 10 years. This would then imply a benchmark contribution rate which is the amount the trustees deem appropriate given the covenant risk. In setting an objective, trustees now have a benchmark which they can use as a starting point for funding negotiations with the sponsor and against which they can compare the adequacy of any funding measures that are put in place. If there is no initial risk measurement, it is much harder to set objectives and to understand the adequacy of solutions. The next step Covenant management will involve negotiation between the trustees and the sponsor to ensure a fair balance between protecting members’ benefits and not overburdening the sponsor. For some schemes, a covenant assessment may be all that is required for trustees and sponsor to agree a funding solution. However, for many others this may not be possible, for example where:
In these situations, trustees can obtain advice from a specialist corporate adviser such as a corporate recovery accountant. The specialist adviser will be able to work with the trustees and sponsor to provide advice on solutions to meet the trustees’ funding objective. For example, if the sponsor could only afford contributions at half the rate at which the trustees would deem appropriate given the covenant risk, then it may be possible to obtain a suitable charge over assets for the remaining amount. Alternatively, it may be possible to put in place a support agreement with a stronger company within the group, or a third party, so the sponsor would be able to remove the deficit over a longer period. In so doing, the trustees would have managed the risk of the sponsor defaulting in line with their original objectives. Funding plans and residual risk The ultimate aim of the negotiation process between trustees and sponsor is to put in place a funding plan that is reasonable given the level of covenant risk. Agreeing a funding plan will often involve compromise between trustees and sponsor, but this should be an equitable compromise. A risk-based covenant assessment at the start of the process will enable both parties to appreciate the residual risk associated with any proposed funding measure. Where funding options are very limited, the funding agreement reached may leave a significant amount of residual risk given the sponsor’s resources. In these situations the trustees might consider, with the help of their actuary and other advisers, ways in which the future volatility of the funding level might be reduced. By setting a benchmark and objectives at the start of the exercise, the trustees’ covenant management process has a framework which allows trustees to appreciate the amount of risk they have managed and the amount of risk they have not. The combination of a covenant assessment with specialist corporate advice might therefore provide a powerful tool for trustees in managing covenant risk. Richard Hall
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