The problem with pension funds

In November 2007, media group Emap hit the headlines with the news that it was selling off its pension fund to insurance company Paternoster. The move was widely regarded as a landmark event, in that it was the first time such a high profile and financially solvent business had sold off its pensions assets, something that had previously been almost exclusively the preserve of the small or insolvent. However, the news merely served to highlight an already rapidly growing trend. Indeed, a report published in February by Aon Consulting showed that the value of such transactions in the final quarter of 2007 had reached a record-breaking £1.9bn – more than twice the rest of the year put together.

What was at the time thought to be an anomalous statistic driven by a small number of particularly large deals has turned out to be a considerably more persistent trend, with the value of buyouts in the first quarter of 2008 increasing again and surpassing the £2bn barrier (see graph). Furthermore, according to Paul Belok, Principal and Actuary at Aon, there is little to suggest the market has peaked: “The quotation pipeline, which provides a good indicator of future business levels, has again escalated considerably and there is therefore a good chance that we will see the market continue to swell”.

Mind the gap

Significantly, many have suggested that it is the desire to make businesses more attractive to potential buyers that is driving this surge in deal activity, particularly if those buyers happen to be private equity firms. The argument centres on the issue of pension fund liabilities, which have historically presented not only a financial headache but a very real obstacle to be overcome in order to get deals done. A case in point here is the high profile acquisition of pharmaceutical retail chain Boots last summer, which saw trustees threatening to block the transaction unless KKR guaranteed the financial security of the pension fund.

The problems are mainly associated with workers who are still years away from retirement, as Keith Bannister, consultant and actuary at Aon, explains: “Firms are being asked to put more money into the pot to make up the liability gap for non-pensioners, which is much more pronounced than that of pensioners because there is a longer mortality risk and a reinvestment risk which have to be paid for”. In the case of Boots, KKR was forced to pledge £418m to the fund over ten years to shore up the scheme before the deal could be completed, and Emap had to top up its fund to the tune of £40m before Paternoster would agree to the transaction. Emap was subsequently successfully broken up and sold off, most notably when the B2B division was bought by Apax Partners and Guardian Media Group for more than £1bn. “Getting rid of the pension fund through a buyout may help with the sale of the business, but its a balance; the cost of topping-up the fund to the buyout level versus the reduction in price if sold with the pension fund”, Bannister adds.

To make matters worse, the first four months of 2008 have seen developments that have served to widen this liability gap. In February, the Pensions Regulator proposed new mortality guidelines, which would require trustees to increase the life expectancy of those within its schemes to reflect the fact that people are living longer. It is estimated that an increase of just two or three years could increase the liabilities of FTSE 100 companies by as much as £25bn. This was followed in April by the announcement that new powers were to be given to the Pensions Regulator to intervene and fine companies if they are seen to have undermined the financial solvency of occupational retirement schemes. Specifically, the watchdog would be able to prevent buyouts by firms seeking to spin off pension schemes without adequate safeguards, and it could even force new owners to inject more money into the fund up to a year after a takeover.

For private equity firms, the moves have simply served to make companies with pension funds less attractive and the new proposals have attracted strong criticism, not least from BVCA head Simon Walker. “There are concerns over these guidelines and it may even result in private equity buyers steering clear of companies with pension funds altogether. There is a lot of resistance at the moment and I expect the regulations to be watered down somewhat before they are officially implemented,” suggests Belok.

Allocations questions

With an uncertain investment climate and spiralling liability issues, it is small wonder then that companies are increasingly seeking to offload their pension assets. What is perhaps more significant from the private equity perspective is how this growing trend is likely to affect overall pension fund allocations to the asset class. According to Belok, the nature of the buyers makes it likely that many of these funds will reduce their allocations: “In many of these cases the policies are taken over by insurers who do not traditionally invest significantly in private equity, the allocations will therefore probably move more towards bonds and maybe some mortgage securities”.

However, due to the growing liability issues outlined above, many of these deals do not concern entire pension funds but merely a portion of the assets, namely those related to members who are already retired. Bannister points out that this has helped to maintain the proportion of the market represented by buyout transactions at relatively modest levels: “The numbers going through are very small - about 0.2% of the market each year, but growing”. With the amount of pension assets being sold already well above historical averages and still rising, it is understandable that if the funds involved in such transactions are more likely to reduce their allocations to private equity in the future the trend should be seen as a legitimate cause for concern within the industry.

In Europe, where pension fund allocations to the asset class have historically been low in comparison to the US anyway, this is a particularly pertinent issue in the current climate, with many anticipating a decline in the value of pension assets due to the poor economic environment. “The public markets are still fairly buoyant, but if they drop substantially pension funds are likely to shrink and therefore even if the percentage allocation remains the same the amount of capital invested could fall” says John Gripton, head of investment management in Europe at fund-of-funds Capital Dynamics.

The current preoccupation with pension funds is evidenced by the latest Perspectives market commentary produced by the group, which focuses almost exclusively on pension funds and the benefits private equity continues to offer. The report particularly highlights the fact that private equity has outperformed the public markets by an average of 2% to 4% over the past 20 years and by as much as 8% with professionally selected opportunities. This equates to a gain of around twice the expected return from public markets over a traditional ten year investment cycle, even taking into account the cyclical nature of private equity performance (see graph). And despite the currently declining returns, Gripton remains confident that most will continue to see these long term benefits: “We’ve been through a period of very high returns that we all recognised would not last and we are now going to see returns more in line with long term historic levels of between 15% and 20%. But even at these levels private equity could still be the best performing asset class and some funds are actually upping their allocation at the moment”.

This is a view largely shared by David McCourt, policy adviser at the National Association of Pension Funds, who suggests that it is unlikely there will be a decline in allocations as a result of the economic conditions. “You have to know what you’re getting into and understand that there will be times when things will not look great. It is about making sure that your long term views on performance fits with your scheme’s liability profile” he adds. Indeed the NAPF annual survey, released earlier this year, reveals that 11% of funds have increased their strategic allocation to private equity in the past two years, while only 2% have reduced their allocation (see graph). Though this is encouraging, McCourt emphasises that there has not been a ‘mad rush’ towards private equity, which he ascribes to an ongoing lack of understanding of the asset class: “There has been a de-mystification of the industry and it is increasingly being seen as something for trustees to look at in order to diversify and not be too over-exposed to market-based investments. However, there are a lot of new investment opportunities out there at the moment that are very hard to fully understand and it’s not an instant win”.

Changing relationship

The new market conditions and shifting liability profile have made the relationship between private equity and pension funds grow increasingly fraught, but they still remain interdependent. Though allocations are comparatively low in Europe, the capital coming from pension funds is vital to the liquidity of the asset class and anything that causes these to drop further is likely to raise concern. In addition, the increasing liability issues, which have long posed an obstacle to private equity buyouts, are now threatening to have a substantial impact on deal flow. For pension funds, in turn, private equity offers a stable, long term investment option that has been shown to consistently outperform the public markets, something that will become increasingly important in the coming months and years now that the economic climate has become uncertain.

From the private equity perspective, importance must continue to be placed on educating trustees on the benefits it offers, as McCourt explains: “There are a lot of other funds and asset classes out there competing for business and some UK trustees still have difficulty assessing private equity, particularly as the money might not even be drawn down for some time and there may not be any return on the investment for some years”. The increasing visibility and transparency of the asset class has had a positive effect but this process must be ongoing and proactive. From the pension fund perspective, it is important that authorities do not let over regulation to turn the perception of the schemes into monsters, which could drive away buyers of companies with funds and therefore prevent efficient succession. If the relationship between these two groups is allowed to deteriorate, there may end up being more widespread implications.

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