Wearing an investor's hat
The pension deficits of the FTSE-100 companies calculated in accordance with FRS17 account for around 3% of the total market capitalisation of those companies. Within this there is huge variation with some constituents having pension deficits of more than 30% of their market capitalisation.
Therefore, any equity investor should be concerned about the impact of pension deficiencies. In particular if the equity market was placing too much or too little weight on pension liabilities then this would provide an opportunity for, or a threat to, investors. Any sponsor of a defined benefit pension arrangement will be interested to know how the market values a pension scheme liability in order for the management to maximise shareholder value.
The academic studies our firm has reviewed as part of our research* tend to show that the market underestimates the impact of a pension deficit. The analysis suggests that this is due to the price-earnings focus of many analysts with the deficit in the pension scheme not being accounted for until it starts to hit the profit & loss account, which may not happen until several years after the deficit has arisen. However, given the US centric viewpoint of the academic research available, the conclusions should be considered with some degree of caution in relation to the UK market.
In the UK, many companies claim FRS17 deficits don’t matter and have commented negatively on FRS17 measured deficits, suggesting to investors that they are not relevant and should be ignored. Often analysts are pushed in the direction of a different funding calculation that invariably shows a much more favourable position. Alternatively, the company emphasises the short-term cash flow costs of the fund, based upon the actuarial valuation, suggesting that it is this and not the FRS17 deficit that really matters.
The actuarial funding valuation based upon a discount rate equal to the expected return on the scheme assets effectively recognises the expected higher returns from equity investment (via the lower valuation of the liabilities) without recognising the associated risk for the sponsoring company. While there is nothing wrong with investing in risky investments in the hope of generating a superior investment return (as long as one is aware of and accepts those risks), one should not anticipate that extra income in advance.
Some of the equity analysts surveyed as part of our research sighted this lack of understanding by investors as a contributory factor to excessive equity investment by pension funds. They note that companies are not only rewarded for equity investment by accountants in terms of presentation in financial statements, but also in terms of their stock price, given that investors largely base investment decisions on the resulting biased measures of earnings.
We concluded that equity market analysts follow the financial economics argument and would, in an ideal world, be treating the FRS 17 deficit as a debt of the company. However, equity analysts often have trouble reconciling this approach with the reality of market prices and investors reactions to changing pension news. Therefore they tend not to follow their first instincts and instead treat the pension deficiency as some form of “quasi-equity” rather than a debt.
Conversely, our research showed that all three of the main ratings agencies S&P, Fitch and Moody’s (who publish their methodology for dealing with pension liabilities) treat pension liabilities, calculated on an FRS 17 basis, as a debt of the company in their assessment of creditworthiness.
Similarly, private equity firms, because they rely heavily on debt funding, are likely to price their transactions taking account of the full FRS 17 deficit because they know that the lenders on whom they will rely for financing will treat any FRS 17 deficiency as a debt. Indeed, our research canvassed the views of investment professionals at private equity houses regularly involved in UK transactions* and over 90% of those surveyed claimed that they priced a pension liability at FRS17 or stronger.
Around 20% stated that they priced on the basis of the full cost of securing the benefits promised with an insurance company which is substantially in excess of the FRS17 deficit. However, in terms of modelling the business going forward, cash costs were seen by half the respondents as being the crucial factor, with FRS17 used by around one-third of respondents.
The private equity firms that participated in our survey felt that placing a company with a significant pension deficit back on to the equity market would get the most beneficial pricing because of the failure of the UK public equity market to treat FRS17 pension deficits as a debt of the sponsoring employer. Two-thirds said a trade buyer would present the best option as they could absorb the deficit within their existing pension deficiencies while a third said an initial public offering (IPO) could be a favourable option as in an IPO a pension position was not a huge area of focus.
The fact that FRS17 deficits are not treated as the debt of a company by public equity investors in the UK has a number of significant implications. First, a company with a significant FRS17 deficit becomes almost immune to a hostile takeover from a private equity house. This is because the equity market does not fully reflect the FRS17 deficiency whilst the suppliers of capital to private equity houses treat the FRS17 deficit as a debt (and hence will place a lower value on the company than a public equity investor).
This results in a weakening of the market for corporate control with pension funds acting as a defence against private equity takeovers, even before we consider the attitude of the Pensions Regulator towards leveraged transactions. Second, executives with share options have an incentive to under-fund their pension scheme knowing that the equity market will forgive a pension deficit but not a foregone dividend.
Our survey shows that two-thirds of private equity houses have already called off transactions due to pension issues and we expect this to continue. Poor management have an incentive to under-fund a pension scheme to prevent the company being taken over and the threat to their jobs that this presents. Equity investors may therefore be well served by encouraging companies to reduce their FRS17 deficits to limit the agency costs imposed by an ineffective market for corporate control.
The fact that UK equity markets may be failing to price pensions as a debt of a company is a very important consideration for any investor in equity assets. If FRS17 deficits are not fully recognised in UK equity market valuations of a company, then arguably there is a possibility that the shares of companies with a defined benefit pension scheme may be overvalued and as such, investors might be wary of investing in companies with significant deficits.
For some investors, such as pension funds, there is an additional reason for avoiding such investments in that these companies are likely to suffer poor performance due to their large pension liabilities just when the pension scheme needs them to perform well.
*‘The market value of pension liabilities’
*16 investment professionals from leading private equity houses regularly involved in UK transactions that contain pensions obligations were interviewed for this study.
Paul Geeson is a principal of Punter Southall Transaction Services, based in the UK