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IPE special report May 2018

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Buyouts take a backseat

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Buy-in deals are taking over from buyouts as the current economic climate stifles access to sufficient capital, finds Gill Wadsworth

From 2007 the UK buyout market enjoyed a considerable boom, writing nearly £8bn (€9.4bn) of new business in 2008 alone. However, while boom has not quite turned to bust in recent months, a sharp change in economic fortunes means players in the bulk annuity market have seen new deal flows almost grind to a halt.

According to Lane Clark & Peacock, buyout quotations have fallen by 60% in the past 12 months, leading the firm to predict 2009 will be a year of "lower quantity, higher quality deals".

The catalyst for the fall-off in buyout deals was the implosion of Lehman Brothers in September 2008. Prior to this cataclysmic financial event there were excellent opportunities for pension funds to offload their defined benefit (DB) liabilities to a third party. A flood of new entrants to the market - eight since 2006 - helped drive competition and push down prices, while corporate bond spreads ballooned out, making buyout a cheaper option. At the same time, funding levels began to improve thanks to a bull market in equities between 2003 and 2007. This meant that buyout providers were able to quote for a greater numbers of schemes.

Buy-in deals were particularly prevalent between January and September 2008, as sponsors that were unable to afford full buyout managed to at least outsource some invest-ment and longevity risk. This period saw the completion of the largest ever buy-in deal, amounting to the transfer of £1.05bn in assets between the Cable & Wireless pension scheme and Prudential.

However, after the collapse of Lehman Brothers the story was markedly different.

"Lehmans went and the markets fell apart and three of the drivers [of buyout business] dropped off," notes Antony Hayes, head of Hewitt's pension risk transfer team. "Corporate spreads seemed to be anticipating defaults and then funding levels fell because the equity markets were shot to pieces, and then people suddenly realised insurers could go bust."

Within months of Lehman Brothers folding, an inability to access sufficient capital began to take its toll on buyout providers. Synesis Life, one of the new players in the buyout space, exited the market having failed to write any new business, and within the last few months fellow newcomer Paternoster has agreed not to write any more business, saying it is unlikely to reopen its doors until some time next year.

However, despite all this uncertainty and lack of available capital, advisers and providers claim the market has not dried up entirely.

"A few deals are still taking place, typically with the big insurance companies. Legal & General and Aviva are still picking up business," says Martin Hunter, consultant at Punter Southalll. "There will always be some pension schemes that have unique circumstances and can enter into buyout."

However, traditional buyout deals are set to be few and far between until 2010, with buy-in looking the more likely route given the economic backdrop.

Consequently insurers are adapting their businesses to meet this new demand. Rothesay Life, which completed its first buyout deal with the Rank Group pension scheme back in 2007, is now focusing on buy-in deals, particularly longevity swaps.

Keith Satchell, Rothesay chairman, says: "We have moved on and evolved during the last two years to look at buy-ins and longevity swaps. We are trying to modify the product and recognise there is a greater appetite for trustees to do something about their longevity risk than there was two or three years ago."

In July the insurer, which is backed by Goldman Sachs, completed the largest buy-in deal by taking on £1.9bn in pension liabilities from the RSA Insurance Group. The company's two schemes retain legal ownership of the assets, which remain invested in a high quality, low risk portfolio of UK gilts and other UK Government guaranteed bonds, while eliminating interest rate, inflation and longevity risk.

Rothesay sees this type of deal as particularly appealing to the larger end of the market where liabilities are so enormous that buyout becomes prohibitively expensive.

"We will see a market at the larger end that is looking for products built around collateral structures with an increasing level of complexity, and who want to break down traditional buy-in or buyout deals into piecemeal transactions, says Jonathan Sarkar, executive director at Rothesay Life.

Similarly, Lucida, which entered the fray in November last year, sees longevity swaps and phased buy-in as the likely source of business, not least for those sponsoring employers wanting to secure any cash injections made to the scheme.

Jonathan Bloomer, Lucida CEO, says: "We had a conversation with a company recently where the sponsoring company is targeting putting in a few hundred million pounds over the next five years. They are asking how they guarantee value for that. We are talking about alternatives and options to guarantee that they get value for that contribution."
However, Punter Southall's Hunter believes longevity swaps are not, at present, an option for smaller and mid-sized schemes.

"[Longevity swaps] are quite complicated products so it's not really worth it for a small pension scheme because the cost of doing the deal is too much. As more deals get done it might be more viable for medium and smaller sized schemes to access longevity swaps; that's certainly what the providers hope," he says.

Rothesay Life's Sarkar believes there may be a greater demand from medium-sized schemes to offload liabilities in their entirety to the market, while smaller schemes are more likely to enter into staged buyouts.

He says: "Mid-sized schemes may be prepared to pay a premium to get rid of the whole scheme, although that will rely on some recovery in equity markets. At the smaller end where companies want to mitigate their risk as far as possible, they will do ongoing tranches such as pensions in payment."

However, he notes that ongoing capital constraints may make it difficult for schemes to secure quotes until market conditions improve.

Once the markets pick up, Hewitt's Hayes believes pension schemes will be more than ready to enter into buyout deals having done all the preparatory investigation and education over the past two years.

"People understand buyout but they don't like the terms at the moment. However, the terms will change and when they do people will buy." He adds: "Provided [the FTSE100 stays above 4500], we think there will be a pick up of interest again."

As the task of running DB schemes becomes more onerous and funding levels deteriorate, sponsoring employers will be ever more eager to pass as much risk as possible to a third party. Although current circumstances mean entering into such a transaction is impossible for many scheme, as soon as markets change buyout business pipelines look set to not only return to the boom times of 2007, but supersede them significantly.

 

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