By Catherine Drinnan and Shaun Thompson
Corporate carve-outs have become increasingly popular in recent years, as buyout firms scour the market for primary deals. In an environment in which the UK Pensions Regulator (the Regulator) is becoming more active, in our view, private equity buyers must better understand the issues and risks associated with seller groups’ defined benefit pension plans (DB plans) on carve-out deals.
Increased Scrutiny From an Active Pensions Regulator
The Regulator is increasingly likely to intervene in transactions, as demonstrated by its response to the collapse of UK high street retailer BHS. The Regulator’s threat to exercise its powers resulted in a £363 million payment to address BHS’ pension deficit. The Regulator is seeking to use its powers more often, and PE buyers must consider this changing environment, particularly on carve-out deals.
Why Pensions Matter on Carve-Outs – Even When it May Seem Like They Don’t
Unlike deals in which a whole group is acquired (with the DB plan factored into the purchase price), pension issues on carve-out deals may not always be apparent in a way that allows for upfront financial planning. The Regulator can exercise its “moral hazard” powers, even if the DB plan is staying behind with the seller. The Regulator’s powers include requiring funding or support up to the level of the DB plan’s buy-out deficit, i.e., the cost of securing liabilities in full with an insurance company, which is usually a material sum.
If the target is a participating employer in the seller group DB plan, the target will need to cease participation, typically via a flexible apportionment arrangement (FAA). FAAs are a commonly used tool, allowing a carved-out company to divest pension liabilities to seller group entities. The arrangements require seller group’s trustees’ consent (which can add to deal timetables) and may require additional funding — it is market practice for sellers to foot the bill, but a significant demand may derail a carve-out deal.
Even if the target did not participate in the seller group’s DB plan, carved-out companies, wherever located, remain connected to the seller group for six years after a buyout, allowing the Regulator the opportunity to exercise its powers long after closing. Deal teams must consider how a carve-out impacts the financial health of the seller group. If a PE firm carves out the most profitable part of a group, it could leave the seller group in a weakened financial position, causing issues for the seller-retained DB plan. In such cases, the Regulator may seek to exercise its powers against the carved-out company.
What Can Buyout Firms Do?
The Regulator has a voluntary clearance regime for transactions, although this can take time. In our view, PE buyers must undertake legal and financial due diligence to assess a seller group’s DB plan and fully understand the relationship that target companies had with the plan and the plan employers. Ultimately, working with advisers and maintaining a dialogue with DB plan trustees (ideally obtaining their support for the transaction) is likely to be the most efficient and effective method for PE buyers to understand and reduce risks.
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