What to do when the wolf is at the door

Next to banks, pension funds are the second largest investor in European private equity. As investors they may be involved, as limited partners, in the leveraged buyouts of companies and their pension schemes - a subject of considerable controversy recently. Pension fund boards therefore face a dilemma: private equity can generate significant returns, which help fund their pension schemes. Yet it also has the potential to create economic and social damage in terms of its impact on employees and their pension schemes.

This month, Off The Record looks at the subject of leveraged buyouts by private equity firms and their impact on pension funds.

It has been estimated that in 2006, private equity funds spent more than $725bn (€470bn) buying out companies. Leveraged buyout firms, as their name suggests, borrow heavily to acquire the companies they target. Once they have made the acquisition, they transfer the debt to the target company. To service this debt, buyout firms will try to reduce a company’s costs.

One of the biggest costs is likely to be the company pension plan. The new owners may reduce contributions to the plan, or even close the plan altogether.

As more private equity firms become owners of companies, more company pension funds are likely to face deficits, capping and closure.

Understandably, the supervisory boards and trustees of company pension schemes have become increasingly wary of takeovers by private equity firms.

In a survey of 250 trustees of UK company pensions schemes by the pensions advisory firm Aon Consulting, three out of four trustees said they would be worried about a possible takeover from a leveraged buyout company.

The biggest worry is that there will be problems of short-term funding. There is also concern that the new owners will put the interests of shareholders before those of pension fund members.

This concern extends in the UK particularly to labour unions who have been in the vanguard of a campaign to give more power to pension fund boards. Some have called for the boards of pension funds to become formally involved in the takeover negotiations of the parent company.

They have also suggested that pension funds be given the power to block private equity deals done by the sponsoring company.

Board members of pension fund themselves are in an ambiguous position, since they may become indirectly involved in takeover bids affecting other company pensions schemes through their asset allocation directly or indirectly to private equity.

So what should pension funds do? What position should they take both to takeovers by leveraged buyout companies and investing in the activities of such companies? We wanted your views.

The replies from pension fund managers, administrators and trustees to our survey suggest that there is general agreement that leveraged buyouts do pose a threat to the health of pension funds. All agree that leveraged buyouts of companies pose the risk of reduced assets and increased debt for the pension funds of those companies.

Forewarned is forearmed, and some pension lawyers have suggested that companies should be compelled to inform the boards or trustees of their pension funds if they receive a bid approach from a private equity firm. A clear majority of our respondents agree with this proposal.

There are some qualifications. One UK pension fund manager says that this compulsion to inform should apply when the bid approach is one that would “lower the credit quality of the firm” and thereby weaken the covenant.

Most respondents agree that pension fund boards or trustees should be involved in negotiations over a takeover approach to their parent company. However, one pension fund manager adds the proviso, “provided there is a large deficit”.

The same proviso applies to the suggestion that pension fund supervisory boards or trustees should have specific powers to block deals or call in the regulator on private equity takeovers.

Generally, opinion is equally divided on this question, and some respondents clearly feel that blocking takeover deals is not a pension fund’s job.

However, some believe that pension funds should have specific powers to call in the regulator on private equity takeovers.

There is also no consensus on the role of the supervisory authorities. Opinion is equally divided on whether private equity bids for companies with pension plans should always be referred to the supervisory or regulatory authority responsible for second pillar pensions.

It could be argued that the need for confidentiality in private equity deals means that pension fund boards and trustees must remain outside the negotiations until the deals are completed. The reasoning here is that interest from potential bidders, if it were made public, could move market prices.

Yet this problem could be resolved with non-disclosure clauses. Three in four respondents think that the need for confidentiality should not bar pension fund boards’ participation in negotiations.

There is across-the-board agreement that the supervisory board or trustees of the company’s pension fund should be able to demand guarantees - for example in the form of up-front cash payments - to secure the financial commitments of the pension fund to its beneficiaries.

There is also the broader question of whether this need for confidentiality should extend to a company’s employees. Most respondents think that company employees should not be kept in the dark about the potential acquisition of their company by a private equity firm.

One of the ways to protect company pension schemes is to move them higher up the ladder of creditors. There is strong agreement among respondents that a private equity business plan should rank its pension scheme obligations ahead of its bank lenders in the event of any insolvency.

Can the (relatively) short-term interests of private equity firms and the long-term interests of the pension funds of the companies they acquire ever be aligned? Some think not. Ron Oswald, general secretary of the Geneva-based IUF, an international union of workers in the food industry, has said: “By their very nature private equity buyout firms cannot have the long-term perspective that recognises the rights and interests of the members of a target company’s pension fund.”

Over half our respondents agree that the interests of private equity firms and the pension funds of their target companies cannot be aligned. One Swiss pension fund manager, while agreeing that buyout firms do not have a long term perspective, suggests “they should be ‘obliged’ to get one”.

Finally, pension funds themselves are significant investors in private equity. Although pension fund investment in private equity typically represents a relatively small portion of their assets, they are the second largest source of capital raised by European private equity firms, representing 26% of the total, and banks (31%).

This creates potential asset allocation conflicts.

The UK’s Trades Union Congress (TUC) has suggested that pension funds may be ‘robbing Peter to pay Paul’ by investing in private equity firms, since the return they make from private equity investment in public companies may come at the expense of their equities holdings in
these companies. “The short-term return from one asset class may create long-term problems that pension funds experience elsewhere in their investment portfolio,” the TUC points out.

Trade unionists who are member-nominated board members or trustees face a different dilemma On the one hand, private equity offers the potential to generate significant returns which help fund their pension schemes. On the other, many trustees will want to invest in a way that does not create social or economic damage.

Yet none of these considerations persuade our respondents that pension funds should steer clear of private equity as an asset class. Three in four see no reason why pension funds should avoid investing in leveraged buyout firms, either directly or indirectly.

A boycott of or ban on private equity investment is therefore ruled out. The message seems to be that, in any conflict between company pension funds and leveraged buyout firms, “jaw-jaw is better than war-war”.