Pfizer’s bid to take over its rival AstraZeneca might have been rebuffed but it does remind us of the ever-present possibility of mergers and acquisitions (M&A) between pension fund sponsors, which can cause considerable problems for the funds themselves.
There is now a widespread feeling that, with the global economy moving into recovery, M&A activity is rising. According to KPMG’s 2014 M&A Outlook Survey of 1,000 M&A professionals, company executives expect to seek growth opportunities through acquisitions during 2014, and believe that deal making will pick up.
The current environment is ideal for M&A, says the survey report, because of low interest rates, the improving US economy and the end of the European debt crisis. Companies and private equity funds have large quantities of dry powder in the form of investable capital.
At a glance
• Merger and acquisition activity is expected to show an uptick this year after a subdued 2013.
• If a sponsor company is involved in M&A, pension trustees should play a role in the process, as it could have major implications for the scheme.
• Key questions for trustees will revolve around the strength of the covenant of the pension scheme sponsor and future affordability.
And while the vast majority of respondents expect North America to be the most popular deal destination, Western Europe – along with China – is expected to be the next most popular.
But the funding level of a target company’s pension liabilities can hinder a takeover, or even scupper it. Permira’s £940m bid for WH Smith 10 years ago was called off following a row between the venture capitalist and the trustees of the WH Smith pension scheme over its £215m shortfall. And Merger plans between British Airways (BA) and Iberia nearly foundered over the combined £3.7bn (€4.6bn) deficit in BA’s two pension plans, which Iberia refused to top up. The deal only went ahead after a clause was inserted in the merger agreement that allowed Iberia to walk away if the recovery plan agreed between BA and the trustees was not “satisfactory”.
A due diligence checklist for trustees
In a merger or acquisition, finance and HR executives usually lead the strategic planning process but pension trustees of both acquirer and takeover target should also be represented from an early stage, according to Heleen Vandrager of Aon Hewitt in the Netherlands, claiming a role in the due diligence as well as integration planning.
Management usually structure the process as follows:
• Deal synergy – what is the reason for the takeover; where will the synergy come from?
• Identify the steps required to achieve the targeted financial returns. If a new company is formed, it could close the existing pension scheme and start, say, an integrated DC scheme, which could cut the sponsor company’s costs.
• Assess the ‘people’ implications (or barriers) within the acquired and existing businesses. Ensure restructuring costs and financial benefits are realistic and achievable within the targeted timeframe.
• Quantify ‘global’ HR-related balance sheet liabilities, expense impacts (such as on the pension scheme) and operational risks.
• Review and quantify key risk areas, such as unfunded retirement or severance programmes, change-in-control provisions, employment agreements, wage and benefits compliance, unions/works councils, and post-close changes to pay and benefit programmes.
• Sale and purchase agreement: commitments to employee pensions and benefits should be clearly stated.
• Organisation and staffing: assess organisation/staffing requirements. Appoint an integration leader and support staff, assess key members of leadership team and implement retention strategies as needed (eg, based on need/risk assessment).
Swiss, Dutch and UK issues
Across Europe, the countries where takeovers may particularly be affected by the status of the target company’s pension fund are the UK, Netherlands, Germany, France and Switzerland.
Increased M&A activity will certainly become an issue for pension schemes, says Heleen Vaandrager, business development manager, Aon Hewitt in the Netherlands.
She says: “The complexity in changing rules and regulations in the pension landscape increase almost yearly. Moreover, the liabilities of DB schemes have become more apparent since 2008.”
And she adds: “Certainly, the landscape in the Netherlands – with renewed financial framework rules for pension funds, the switch from DB to defined contribution (DC), obligatory pension funds with specific rules and conditions for staying in or leaving the fund, do create a pawtchwork of obligations and complexities for the employer to deal with where M&A activity occurs.”
In Switzerland, a big problem can arise when an international company with operations in Switzerland takes over a smaller Swiss company, says Peter Zanella, head of retirement solutions at Towers Watson in Zurich.
“There is often a mismatch over how pension liabilities are valued, because Swiss companies can use Swiss generally-accepted accounting principles (Swiss GAAP), rather than International Financial Reporting Standards (IFRS) or US GAAP,” says Zanella. “Swiss GAAP liabilities are usually valued and funded using a higher discount rate than according to IFRS or US GAAP, so the real settlement liability figure is higher than the acquirer’s estimate, and this can be a real deal killer.”
But he says the acquirer’s due diligence should highlight this discrepancy; one solution could be to adjust the purchase price.
Adam Rosenberg, UK head of M&A at Mercer, says: “Many acquiring clients are fairly savvy, and are taking the time to look at the pensions issue. Many organisations buying and selling companies now look at pensions as a debt-like item.”
Although the prime movers of mergers and acquisitions are going to be executives of sponsor companies, pension scheme trustees should also get involved, as there will be implications for their pension funds.
They may even have certain rights in relation to the process. In 2013, the UK’s Takeover Panel changed the City Code on Takeovers and Mergers, to give trustees of funded DB schemes enhanced powers during a takeover.
These include the right to information as to the acquirer’s intentions on contributions to the scheme, future accruals and admission of new members. Trustees can also now attach their opinion on the offer – and what it means for the pension fund – to the target company’s communications to shareholders.
Whatever the legal rights and obligations, however, Rosenberg stresses the importance of dialogue between the acquirer and the trustees of the acquired company’s pension scheme. And from the point of view of the trustee, Rosenberg says the key issue is the covenant of the acquiring company and its strength. “The question is how long is the company likely to be around,” he says. “Will it be able to pay all pensions in the future?”
A further challenge arises where the acquirer is owned by an overseas parent and it is more difficult to work out the overall strength of the buyer’s covenant. Here it is important for trustees to understand the financial structure of the business before the deal happens.
Cashflows to and from the business, before and after the deal, should also be compared. For example, where will the money come from to fund the pension scheme?
Trevor Civval, partner with corporate finance adviser Penfida, says that trustees should look at how the transaction is being financed. If financed primarily with debt, does the transaction impose an increased level of risk? Does the scheme’s position as a creditor change? Are other creditors such as banks in a better position? How are the long-term prospects of the sponsor changed by the transaction and what is the impact on affordability? If the answers show a negative impact on the scheme, Civval says trustees should consider whether they can negotiate appropriate mitigation.
Other questions for trustees include:
• What are the acquiring company’s intentions towards the pension fund – will it make changes and if so, what?
• If the pension scheme is still open to new members, will it be closed after the deal?
• Will the pension scheme be harmonised with the existing pension scheme of the acquiring company? If so, trustees should consider benchmarking the plans so as to compare existing and new arrangements. Acquiring companies are likely to demand a decrease in benefits.
• Will grandfathering be an issue if the scheme changes – will arrangements for current members remain the same?
• What if things don’t go to plan? How robust is the backing for the pension scheme?
• How should the company communicate the changes in the pension plan to members?
Zanella points out that poor communication can lead to a less motivated workforce, while Rosenberg says that the long-term cost of paying for the pension scheme should be priced into the takeover deal by the buyer. He says: “In our experience, this has been anything from an accounting cost to buyout. The value of pensions can often be a material item in a deal and can have substantial implications to pricing the deal.”
Redundancy breeds complications
A takeover often means redundancies at the target company – and this can complicate matters for the pension fund.
In Switzerland, the law requires a partial liquidation of the pension fund to cover the cost of present and future payouts to staff who leave.
But where the scheme is underfunded, how much of the assets can it retain?
“There is no legal obligation on companies to bridge this gap, and some companies have not done so,” says Peter Zanella, head of retirement solutions at Towers Watson in Zurich. “In this case, those scheme members who are left may see their benefits go down, even though they have been assured that these are guaranteed. The acquiring company needs to make sure that it knows who is funding that deficit – and so do the pension scheme trustees.”
Nuts and bolts
Once a merger or takeover has been agreed, the decision has to be taken as to whether to integrate both of the funds or leave them as standalone schemes. Integration can present a challenge. According to Rosenberg, this should encompass the total reward strategy of the resulting organisation, to include salary, bonuses, share plans and flexible benefits.
“If the businesses will not be integrated, management should ensure that people at different levels in both businesses are paid appropriately,” he says. “If they are integrated, management should look at providing a similar reward and benefits structure going forward, though they don’t have to be the same.”
Buyers, for their part, should consider the level of state benefits – which differs widely throughout Europe – in order to arrive at the overall level of employees’ retirement income after the takeover or merger. This can act as a further complication for takeovers involving more than one country.
In the UK, many of the benefits of integration can be implemented through common trustee boards, and by introducing a single governance structure, with single advisers and administrators working in close conjunction, for example, all meeting on the same day.
The first step in integration will be to develop a global integration plan, says Vaandrager: “This will cover the new organisation structure, restructuring synergies, cultural values, labour relations, compensation, benefits and employment practices.”
Trustees will again need to ensure they take an active role in agreeing the integration process. Indeed, in Switzerland trustees can actually block changes, although this does not often happen in practice.
Communications with all stakeholders should also be planned well in advance, with a timetable showing which key messages should be given when. “Otherwise, some people find out what’s happening before others, and that creates ill-feeling,” says Zanella. “The more you invest in a good communication strategy, implemented in a professional way, the fewer problems you have with integration.”
It is also vital to ensure that the funds are valued using the same assumptions, and are brought to similar funding levels.
Zanella also warns that in Switzerland, international companies often offload the headache of their pension scheme by outsourcing it to a multi-employer plan – which will be an issue if they acquire a company and harmonise its pension scheme with theirs.
“Some multi-employer plans do not always provide the same level of benefits as a company scheme,” he says. “And it will still carry some risks, such as longevity and investment risk.”
Problems might also occur where a company has previously given commitments to its pension scheme or members, in which case Rosenberg suggests ensuring that all historic communications are carefully reviewed – it is better to be knowledgeable up front if commitments have been given in the past.
Meanwhile, Vaandrager reminds trustees of the paperwork needed once the integration arrangements have been agreed. This includes notifying the applicable global benefit governance committees of all transactions and proposed benefit programmes.
The date of closing of the deal should also be confirmed to insurers, and additional cover started, if necessary. This might include top-up benefits for certain key staff whose benefits might otherwise be reduced in order to harmonise with the acquiring company’s scheme.