Briefing - BVCA admin

Yet this investment strategy generates a lower return and the
trustees are now only able to count on a return of 4%. In turn, this
pushes out liabilities, under TPs, from £180m to £230m.
Given that, in their view, the corporate covenant has weakened, the
trustees now want to shorten the duration of the recovery plan and
extract maximum value. This means that company contributions
shoot up to £22m over five years, rather than the relatively
manageable £5m for 10 years.
The trustees have had a huge, unforeseen, impact on the assumed
25% IRR.
If the impact of the trustee’s view of Opco leverage and change
in investment strategy had been taken into account prior to
acquisition, then it is possible that the GP would have taken the
strategic decision not to acquire the Opco in the first place, precisely
to avoid this ramping up of essentially open-ended pension
contributions. Alternatively, prior to taking on the leverage, the
GP might have looked at its options and passed the pension fund
to a third party, usually an FSA authorised and regulated insurance
company, through a pension insurance buyout or buy-in.
If they retain the pension fund, the bad news for management
is that they could face even higher contribution rates at the next
valuation – as will many of the sponsors of the c.40% of pension
funds which had their triennial valuation in March 2009, with the
next one due in March 2012.
In 2010, over £29bn in contributions were paid by the private sector
to defined benefit pension funds and a recent survey of trustees
carried out by Pension Corporation found that 55% of them expect
employer contributions to go up by more than 10% after the next
valuation.
So post the restructuring and the pension plan renegotiation, the
GP now receives £6m per annum for five years from the existing
business, increasing to £28m from year six onwards. At the same
WACC, the NPV of company’s cash flow is now only £235m.
Without the burden of the pension plan, the GP at this point would
have been better off to the tune of £55m.
Legislation risk
There can be no doubt that defined benefit pensions funds have
been steadily rising in terms of cost of management time, running
expenses, and increasingly in the need to make good deficits.
Deficits have increased due to several factors, including
underperformance of risk assets, increased liabilities that have not
been matched by hedging assets such as bonds and swaps, benefit
uplifts granted in the 1980s and 1990s - such as enhanced early
retirement - and of course ever-increasing longevity, something
which has only lately been recognised by pension fund actuaries.
There has however been another factor at work, which has
significantly increased costs: legislation. In fact, we estimate that
four pieces of legislation alone have added approximately 44%
to the cost of running a pension fund over the past 30-40 years:
making pension increases guaranteed rather than an intention
added 12% to the cost of running a pension fund; requiring the
prefunding of technical provisions with a prudent margin added
8%; the removal of ACT for equity dividends added 12%; and
the PPF levy and compliance with the Pensions Act 1995 added
another 12%.
These additional costs have all been borne by the employer, and in
the case of private equity, the GP, heavily impacting IRRs.
Relative to the costs of securing the pension liabilities with an
insurance company pension fund investments are in general
significantly misaligned.
Pension funds have been hit again and again by the double whammy
of stock market crashes reducing asset levels, whilst collapsing gilt
yields push up liabilities. During July and August 2011 alone we
estimate that UK private sector pension funds collectively lost in
excess of £200bn relative to their liabilities.
When they were less mature, pension funds had good reason to
invest in equities. From 1974-2000 the average annual real return
on UK equities was 13%. Given the high returns experienced in
the equity markets, and the tax incentives of operating defined
benefit pension funds, operating a pension plan was historically cost
efficient for the employer.
However, as pension funds move to run off, this position has in
many cases changed.
Take for example for a pension fund with £100m of assets and
£130m of liabilities, which, under its existing recovery plan, is to
invest 100% in equities. If the trustees don’t hedge the interest rate/
inflation exposures, which most do not, there are some potentially
severe consequences for the employer. In effect, the employer has
granted a put option to the Trustee on 10 year equity performance
and real interest rates at durations in excess of 10 years; the
employer is therefore liable to meet the underperformance of the
equities against the projected returns – in this case the extent to
which £100m of equities fails to grow to £197m over 10 years.
If the pension fund assets outperform, the outperformance will be
of little value to the employer; surplus generated will be used by the
trustees to de-risk or be held in the fund as a buffer. The equity risk
is one way for the employer.
The trustees therefore effectively have a 10 year put option on
equity market performance which starts off £97m in the money. The
cost of the same put option, if it were to be bought in the market,
would be £63m.
Given the complexity of a pension fund and the power the trustees
can wield, it is unsurprising that increasing numbers of GPs have
been transferring these substantial, open-ended risks to insurance
companies. The employer benefits by divesting itself of any future
responsibility, financial or otherwise, for a known and pre-agreed
amount paid as premium. The pension fund members benefit as
the insurance regulatory regime ensures their benefits are secure,
backed by shareholder capital. In effect, this is a demonstrable
strengthening of the covenant supporting the liabilities and can be a
considerably cheaper option for the employer. n
Autumn 2011 BVCA Briefing 25