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OPDU Report 27 June 2010 - Annual Risk Conference Special Edition Pensions and corporate activity – a case study
“Many businesses were bought by private-equity firms using large
amounts of debt and only thin slices of equity.” This article arose from a talk which I first gave at the NAPF Annual Conference in October 2008. Its genesis was the frenzy of corporate activity in the years leading up to the credit crunch, and the implications of this activity for the corporate covenant provided to pension schemes by corporate sponsors, especially when, as was the norm at the time, the corporate activity was backed by large amounts of leverage (or debt as we used to call it). The article takes the form of a case study. I must stress that this is an entirely fictitious case study which I dreamt up one day, and is not related to any real case, although it is designed to show what can happen in a real case. The figures have been checked over by a qualified accountant, but any residual errors are mine and mine alone, as are the opinions expressed. The example is very simplistic, but the actual figures used are fairly irrelevant – it is the principle which is important. Imagine a conventional, profitable, quoted company. It has £300m of fixed assets, mainly in the form of property. It also has £100m of bank debt secured against this property, £30m of unsecured debt (suppliers and so on), and a defined benefit pension scheme with a buy-out deficit estimated at £150m. It has 100 million ordinary shares in issue, with a market value of £1.50 each. The pension scheme trustees have had a covenant analysis carried out. This has told them that, in the event of insolvency, the fixed assets (£300m) would be sufficient to pay off the bank debt and the unsecured debts (total £130m), and would still leave enough to pay the full buy-out deficit with £20m left over to pay the ordinary shareholders out at 20p per share. Even if the unsecured debts were to rise to £50m, the pension scheme would still be satisfied in full. The trustees are contented with their lot. Let’s look at where the risk lies in this company. If its business does well, the ordinary shareholders will also do well, by way of increased dividends and consequently a higher share price. If business is poor, the same shareholders will suffer reduction or possibly suspension of dividends. In other words, the upside and downside risks both lie in the same place – with the ordinary shareholders. I may be old-fashioned, but to me that is the way it should be. Ordinary shareholders own the company and their equity represents the risk capital. So far, so boring. But now a leveraged bidder arrives on the scene, with £400m of financing arranged. £100m of this is to be used to pay off the bank. After tortuous negotiations, threats and so on, £30m is paid into the pension scheme by way of compensation for the trustees. The remaining £270m is used to buy the 100 million ordinary shares at a price of £2.70 per share – a whopping 80% premium on the share price just before the approach. The resulting structure will have £300m of secured debt (secured against the fixed assets): £200m owed to an investment bank and £100m to the new equity owners. It will have an unchanged £30m of unsecured debt, and a pension scheme with a buy-out deficit of £120m. Its equity consists of 50 million unquoted shares with a notional value of £100m. Not surprisingly, the company directors accept the bid (after all, they do have the interests of the share-holders to consider). As for the shareholders, their main question is “where do I sign?” Neither of these groups of people can be criticised for accepting such a generous offer. The position of the pension scheme trustees is less happy. They have another covenant analysis carried out. This shows that, in the event of an insolvency, the fixed assets would all be needed to pay off the secured debt. Nothing would be left for the unsecured creditors, the shareholders, or – and this is the key point – the pension scheme trustees. In addition, the interest charges on the greatly increased debt burden make insolvency more likely. Who takes the risk in this new structure? Clearly if the business does well, then the ordinary shareholders will benefit – in fact, the leveraged nature of the structure means that they will benefit more than propor-tionately. But if it does badly, the picture is much less straightforward. The ordinary shares will have no value (but remember that the ordinary shareholders also had, and will have recovered, £100m of the secured debt). The unsecured creditors (suppliers and so on) will lose out, but this is a risk which they have to take in the course of business and which they can probably insure. More importantly, from our perspective, the pension scheme will not recover anything from the failed company, and it will presumably end up in the PPF. The members of the scheme will lose out to the extent that the scheme benefits are not covered by the PPF: and the PPF itself, and hence levy payers as a whole, will lose out to the extent that the scheme’s PPF liabilities are not covered by the assets. So what has happened here? How has a corporate transaction managed to hurt pension scheme members who previously had a solid company covenant? Fundamentally, the shareholders were overpaid for their shares. The business was not worth £2.70 per share. It might have been in certain circumstances, but in those which prevailed it was not. And the new structure meant that the business was financed by a large amount of high-ranking debt rather than low-ranking equity. In effect, the risk of business failure was moved from the original shareholders to the new shareholders, but also to the pension scheme members and the PPF. This cannot be right. Ordinary shareholders should expect to take risk – that is what equity is for. Business creditors should – it can be insured. But pension scheme members should not: they cannot diversify or mitigate that risk (particularly if they are pensioners) and they are most unlikely to benefit if things do in fact go well. What lessons should we, and our legislators, learn from this? First and most important, risk should be symmetric. That is, the potential winners should be the same as the potential losers, and to the same extent. Second, risk should only be passed to those who have a choice: who can diversify, mitigate or otherwise reduce or eliminate the risk to which they are exposed. Those who cannot do this, and who will not benefit in the good times, should not be expected to bear the failure risk of a corporate transaction. It is unfair for pension scheme members to face avoidable losses as a result of unnecessary financial engineering. Peter Thompson
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