The power of the trustee on the mergers and acquisitions battlefield

In a roundtable discussion forum sponsored by Goldman Sachs, industry leaders discuss matters such as the role of the trustees, how sponsor covenants can be maintained during the takeover process and how pensioner savings can be safeguarded

Life & Pensions - What is the role of pension fund trustees in takeover discussions?

Terry Monk - A fairly simple answer is that the role of the pension fund trustees is, at a very minimum, to strengthen or protect the position of members, and certainly not weaken the position of the members.

David Archer - The regulator is encouraging trustees to put themselves in the same position they would be if they were a bank lender, for example, or one of the senior unsecured creditors. In our experience, it seems that the role of trustees can vary hugely depending on the circumstances of a particular deal, and that's one of the reasons it is so hard to generalise. You get friendly deals where there are solid covenants around and the trustees can take a fairly passive role, or you get highly leveraged roles where the trustees need to take a very proactive role.

Jonathan Clarke - I think a lot depends on the strength of the covenant. In my case I've been involved in two transactions - one as treasurer of the company when RHM floated from private equity ownership. It has to be said that, as treasurer, you have a very different view to that of the trustee. Then, when the company was sold to Premier and I was asked to lead the working party of the trustees to negotiate with Premier, I had a trustee hat on and that was very different.

Nigel Casson - I have been involved in three disposals of participating companies in the Invensys pension scheme. Throughout that, the role of the trustee has basically been to try and ensure that the sponsor's covenant improved and to secure the security of benefits for members. It's fairly straightforward.

Lesley Alexander - The trustees are in quite a difficult position because there is no obligation, effectively, on the target company or the bidders to actually engage with the trustees. That means that the trustees have got to have a very good, open relationship with the existing sponsor in the first place. You're heavily reliant on the sponsor company actually being prepared to support your position as trustees; to actually give you early engagement with potential bidders. I agree that it comes down to what the covenant is like before and after the transaction, and getting the information early enough to be able to process it and form an opinion on what that covenant will look like.

Jonathan Clarke - As trustees, you're one of the last to know. You typically know about a deal once it hits the public domain. It's certainly one of the issues that we have grappled with at RHM. Before the acquisition, I was doing scenario-planning with the trustees, just trying to bring them up to speed about what the implications are - issues of leverage, for example - getting the trustees on the same playing field so, if there was a bid or disposal that would significantly alter the shape of RHM, at least they could assess it intelligently without any preconceptions.

Terry Monk - I think the difficult thing is if you're sitting on the trustee board as finance director and trustee, and you know that these negotiations are going on and the impact on the pension scheme and the members, exactly where does your duty lie? Do you have a duty as trustee to disclose that information when you probably shouldn't be disclosing it as finance director?

Jonathan Clarke - I think the duty of obligation is very clear - it is to the trustees. I think that is why you are seeing so many financial directors and treasurers stepping down from trustee bodies. Equally, that works against the trustees in many respects because they then lose the benefits of corporate knowledge.

Stuart Cash - A big issue is equality of information between what company directors see, what bidders see and what trustees see. It's not as easy for trustees to get their hands on management information or to have as much industry insight as the bidder might have.

Jonathan Clarke - The trustee is in a position of being an inadvertent lender in many situations but, quite frankly, has a much higher economic exposure to the company than any of the lending banks, for example. It should be entitled to the same sort of forward-looking information that the lending banks get in terms of evaluating a deal.

Jerry Moriarty - If you're an independent trustee, I think it's probably more straightforward to protect the fund. If you're a mixture of employee and employer representative trustees, you're also caught up in the whole issue about your job and the future of the company. I think it is probably very hard for those individuals to divert themselves from that. I'm aware of one situation in Ireland last year where the trustees started buying up shares in the sponsoring company to prevent a takeover. That was certainly something that raised eyebrows at the regulator.

Nigel Casson - Our experience has been that the introduction of the regulator has helped the trustee in the process. The company as a whole - if it wants the deal to go through and it wants clearance and everything else - has been forced to bring the trustee in at a relatively early stage to what would have happened some years ago. That has helped the information flow and the discussion. It adds other problems like confidentiality agreements for trustees and all sorts of things like that, but my experience is certainly that it has helped us in recent years.

Stuart Cash - I think there are two issues that corporate acquirers and sellers of businesses are having to familiarise themselves with. One is tactical - if you're a trustee, when is the right time to put your hand up and say 'talk to me now'? When does your leverage change in the process? If you're an acquirer, when does your leverage change in the process? The other issue is technical - what is the right liability number? The number you see on the accounts may not be the number the trustees or the regulator wants you to focus on.

Lesley Alexander - That is where the materiality issue comes in. If you don't engage early with the trustees and do your due diligence and you're just looking at an accounting number - as a bidder you can come unstuck.

Life & Pensions - How can trustees maintain a robust sponsor covenant before, during and after takeovers?

Terry Monk - There are a lot of small to medium-sized schemes and members of those schemes are potentially more vulnerable than larger schemes because they haven't got the wealth of advisers around them. When you get down to the covenant review, I think you've got two questions - is there ability on the trustee board? And, secondly, do they know the questions to ask to make sure the covenant review is relevant? They don't want the covenant review driven by the firm that is doing the review. They want to drive it by the circumstances and issues around the scheme.

Jonathan Clarke - As a trustee, if you want to have an informed view on valuation issues, you have got to have a good understanding of the covenant. You need more than just relying on published information. Trustees don't take a huge amount of notice of IAS 19 or FRS 17. It's a yardstick used by corporates. The key one the trustees look at is either the ongoing funding or buyout.

Lesley Alexander - Because IAS 19 is about best estimates, it is not about prudence, which is more the regulator's guidance. The new clearance consultation makes much more reference to section 179 (Pension Protection Fund) valuations than previously.

David Archer - It is an important point that the company leveraging-up doesn't necessarily weaken its covenant if it strengthens the business and the business model of the company going forward, and trustees have to understand that. The transaction I was involved with in the summer was fully leveraged; all of the company's assets were being leveraged against the balance sheet so, on paper, the covenant turned from being quite a good covenant to being a poor covenant. As trustees, we addressed that by ensuring that we had first-ranking security so that, at least, we were in a better position than we were before. It was a bit surprising how some of the senior lenders were really very resistant to that idea. In the end it was all fine, but it took some time for the penny to drop.

Jerry Moriarty - I would have thought, just looking in from the outside on this, that trustees do have a lot of real power in that, at the end of the day, they are in a position where they can scupper the whole deal, and that gives you some leverage.

David Archer - If the parties decide to proceed without clearance, then the trustees may not have nearly such a strong negotiating position. I presume the trustees have the option of using the regulator as well.

Jonathan Clarke - In my experience, the regulator's stance is that they really want you to sort it out with the company. They don't want to play teacher unless they absolutely have to.

Lesley Alexander - The two main areas where I think trustees have some strength is in the scheme-specific funding, because it is within the power of the trustees to call a valuation at any time if there's anything material that they believe affects the fund and its ability to secure the benefits. While that in itself creates an awful lot of work for the trustee board and its advisors, it's one thing that they can do at any point.

The other, of course, is the investment strategy. The company are required to be consulted on investment strategy. If the trustees have considerable concerns about the security of the benefits and they think they're taking an inappropriate level of risk in the fund, then their option is to de-risk as rapidly as possible. That is inextricably linked with the funding anyway, so that will have a knock-on effect. Outside of that, I agree that the regulators' powers can be quite nuclear.

Stuart Cash - My sense is that the world has changed dramatically in the past two years. Partly because prudence is an important issue for trustees now, the CFO has got to play catch up with where trustees have got to; before, he was playing catch up with FRS 17 and IAS 19. I think the goalposts have just completely moved. We think that's probably the right place to be.

Terry Monk - My view is that funding to buyout, unless you really intend to do it, is not necessarily the best use of money and you're creating assets in your pension scheme for the benefit of the buyout provider. Funding somewhere close to that and above PPF is right - I slightly worry that we're having a PPF level of funding. To me, that has raised the bar, but the scheme should be funding not at buyout, but close to it, and above PPF.

Life & Pensions - There used to be a less conservative valuation consensus between the sponsor and the trustees, which is disappearing because investors perceive corporate assets as being something they can work harder using leverage.

Jonathan Clarke - I think that's right. If you look back even a couple of years, quoted UK plc was probably relatively undergeared. Trustees could be very comfortable with having a bit of flex in the funding. If you suddenly move from that, and that's typically investment-grade unsecured lending, and move forward saying that the same company is now four, five, six times leveraged - a ton of secured debt ahead of you - of course you're going to look at a more conservative valuation.

Stuart Cash - It's a simple formula coming from parts of the regulator, which is assets plus covenant equals buyout. It basically means that if your covenant is weak, you clearly need more assets to get closer to buyout. By definition, better covenant means you can have less assets and a lower funding target. That's a simple way of looking at it, but I actually think it's quite effective.

Terry Monk - If you've got a weak covenant and you want to be more robust about your funding, you end up having an even weaker covenant because you're chasing more secure but perhaps not currently affordable funding objectives.

Jonathan Clarke - If you try and assess what the risk in the scheme is and what the covenant is, at least you then know what you are dealing with. Then you can assess if it's better for money to be in the company rather than the pension scheme and whether if you strip money out of the company you run the risk of it breaching its banking covenants.

David Archer - To what extent do you consider that the dynamic becomes more complex when the scheme is open to future accrual? When it's a closed scheme and closed to future accrual then the trustees are simply in the position of an unsecured creditor and want to protect that position historically. When you've got an open scheme, at least to current accrual, the trustees are keener to keep a good working relationship going with the employer.

Jonathan Clarke - I don't think that changes. A scheme is still a liability whether it's open or closed. Because it's closed, it doesn't mean you have to have a more adversarial versus friendly relationship with the company. There's obviously a different set of issues but, really, the role of the actuary is making sure that, if there's an open scheme, they've learned from mistakes of the past and are factoring in fully things like mortality, and so on and that the ongoing service cost is being recouped.

David Archer - The trustees' duty is, primarily, to protect the existing benefits, but the trustees may want to keep a more cordial relationship going forward in order to encourage the employer to keep the final salary pension scheme alive.

Lesley Alexander - But that's not the responsibility of the trustees. Subject to the powers in the Trust Deed and rules, law, contract or whatever, the company can change the terms and conditions for employees at any time. In some ways, that's not always a negative step if it's part of negotiations around what you do to protect the accrued benefits for those members. If the company is struggling to meet the demands of the final salary scheme and it needs to change its benefits structure, that's surely part of the negotiation for the trustees and the company.

Jonathan Clarke - The RHM scheme is still an open scheme, which is pretty unusual these days. When we were taken over by Premier, we made sure that Linklaters briefed all the trustees very clearly that their obligation is to accrue benefit, not future benefit. It doesn't mean to say that you adopt a more or less adversarial approach with the company, because I think the company and the pension scheme have got to be absolutely entwined in many respects. Fundamentally, the only person who writes a cheque out is the company to fund the pension scheme in terms of any deficit.

Stuart Cash - When you've got an open scheme, I do think you have a balance towards the continuity of the employer in a much more shareholder-friendly way. A major acquisition that will be synergistic and boost the profitability of the UK entity, which results in continued employment, probably you'd be more amenable when you've got an open scheme. Where you've got a closed scheme the balance of risk may not weigh the same way towards you as a trustee.

Terry Monk - It's difficult for the employer to take that business forward if you've got an open scheme and you've got the ongoing accrual on top of the ongoing open responsibility for the employees that are not working for you today. You've probably got a bigger group of members that you acquired through an acquisition 10, 15, 20 years ago, and your responsibility as an employer has almost been weighted by people who don't contribute a thing to the company anymore. They're a sort of legacy liability. As trustees, you have to treat everybody equally.

Lesley Alexander - Current employees in defined contribution don't necessarily have a stake in the defined benefit plan. Sometimes, we perhaps concern ourselves too much with what the employees think about what the trustees are up to because a large proportion of the workforce in some companies don't have an interest in it anymore.

Stuart Cash - I'm interested in how to maintain a robust covenant. If a company's covenant goes down, is there a trigger to provide enough security or change the nature of the liability valuation? It's the same way you would think about things if you were a lender.

Lesley Alexander - I think you should actually build those sorts of things into any agreement that you reach between the trustees and the sponsor. Sometimes we talk about this as though it's a one-off 'now' type of decision. I don't think it is. If you're in a position of doing an assessment on covenant pre and post transaction, I think you should be hoping, as trustees, that all these expectations for the business going forward are actually fulfilled post transaction. I think trustees have a duty to continue monitoring the situation and to put in these hooks that say we all go back to the table at this point because either the funding level has dropped to this position or you're talking about refinancing again in some particular way. I think it has to be a dynamic relationship.

Life & Pensions - How can trustees safeguard pensioner savings in the face of private equity buyouts?

Jonathan Clarke - I actually dispute that private equity is necessarily bad. I've worked with private equity and public. In many respects, private equity owners take a longer-term view than public owners. It's all down to how you're moving in terms of leverage.

Stuart Cash - I think the question on safeguarding interest is really what tools do trustees have available and how do they use them. I'd say that the biggest challenge for trustees is knowing how hard to push. I've seen instances when the company treasurer has sat with trustees and, even though he was treasurer, very much fulfilled the trustee role because he understood the company and the financing.

Terry Monk - It's not being too greedy, maybe with the size of the wedge. It's being realistic.

Lesley Alexander - I think part of the scheme's funding negotiation is that the trustees have to be prepared to consider a range of options. It doesn't always mean cash. It can mean escrow, charge over assets, parent company guarantee. Again, in this situation I think all of those options can still be on the table - from an acquiring company as well. It's what value the trustee places on any alternatives to cash.

David Archer - You can be recklessly prudent if you just say no, I'm not going to budge, the whole time.

Terry Monk - It's about what the acquirer objective is. Ultimately, it might be good sound business sense for the acquired business, which gives greater protection and security for the trustees and the members. If a venture capitalist is coming in, you've got to ask why. He's not coming in to lose money; he's coming in to make money. Over what period of time does he want to make money? What is his objective; what is his exit route for the business, and when? And what will the impact be on the scheme, the business and the members when he does exit? Is it an opportunity to maybe get hold of some hidden assets in the pension scheme or from the business?

Stuart Cash - A lot of the time we sit in the middle. Part of the issue that most trustees and companies face is not realising how much common ground there is between them. When you leverage up a company, suddenly the equity value of the business is a lot smaller so the pension fund is, by definition, a lot larger relative to the business or the equity - and it's as much a concern for treasurer, CFO or the CEO as it is for the trustees. Our perspective is that there needs to be more talking about what common objectives are rather than finding differences.

Life & Pensions - How are the risks to the scheme managed before and after takeovers?

Terry Monk - The thing you need to understand as trustees is what does the employer want to see happen to the scheme, over what period of time does he want it to happen and how much risk is he prepared to take to get to that objective? Does he want to gamble his chips, put it all on black, and have a high-risk strategy in the hope that he might get there? Then the trustees come back and ask for bit of additional security.

David Archer - Schemes have to have a statement of investment principles (SIP) and that has to go to an employer for consultation. It's very unusual to end up being at odds with an employer. We've only done it once where we had to, but otherwise it's a collaborative process. Assuming that the company's covenant means they'll be a continuing employer, it's their risk if the covenant is going to be an acceptable one. One way or another, it's embodied in writing in an agreed document.

Jonathan Clarke - The attraction of RHM to investors was low growth, relatively high dividend, so the protection of the dividend was of paramount importance. Working back, what was the maximum amount we could borrow while still paying a dividend? That gave us roughly a limit over and above our existing facilities or our existing borrowings. Therefore, from the company to the pension scheme we said 'we're happy with you running a VaR of around £200 million'. That gave them around 1.5% over-performance compared to the actuarial assumptions, which meant that the debt would be paid off quicker than under the actuarial assumptions. That was what we wrote into the agreement in terms of the SIP. From a company viewpoint, once you've set the return and the risk, how the pension scheme then allocates that risk budget is up to them to an extent. Obviously, the role of the company representative on the investment committee is to make sure that they've got competent advisors.

Lesley Alexander - From our perspective as trustees, you don't want a high degree of risk in the business and a high degree of risk in the pension scheme. I think that's the fundamental of it. The SIP that we have already sets us on a path of gradually de-risking, so there have already been discussions with the sponsor about how we get from the current asset-allocation strategy to where we want to be. Then, there's a framework for having further negotiations and deciding what the next step of that de-risking process will be. I think that comes down to whether you take something like the SIP as just a compliance document or whether you consider it to be something that is much more strategic and useful for the trustees to consult on regularly with the company. It sets the direction for the trustee board.

Life & Pensions - Are pension buyout firms saviours or snakes in the grass?

David Archer - The good news is the cost of buyout quotes has come down in very general terms.

Terry Monk - If it provides a secure solution, then it's one that trustees can consider alongside a lot of other investments and investment strategies. To me, it's an investment tool. Is it better as an investment tool to pass the assets to Paternoster or whoever the buyout provider might be? Or is it better to get more and more secure funding within the scheme and keep the assets within the scheme as opposed to paying it to a product provider?

David Archer - You still pay a massive premium for de-risking the mortality risk by buying out, don't you?

Terry Monk - I think you carry a big risk by keeping the mortality risk within the scheme.

Jonathan Clarke - Ultimately, whether you want to take that mortality off the table now or roll it in over the next ten years or whatever is a corporate call. As an FD or treasurer, I guess you're going to be thinking do I want to pay 130% of what I need to to get it off the balance sheet, whereas the worst case possibly over the life of my share options is 105-110% - on any meaningful-sized scheme it's a big cheque to write out to a Paternoster or whatever and you're always going to be thinking that the reason these guys are in it is because they can do it better than you.

David Archer - The solvency of buy out providers needs to be considered by trustees. If there is a 'wonder drug' that pushes longevity way up then they've banked their viability on it.

Jonathan Clarke - I guess it will be interesting to see how it evolves over the next couple of years. If you're in a scenario where you're already fully funded to buyout, you probably think 'I can't get the money out so if somebody is prepared to pay me that for it I might as well get it off my balance sheet.'

Stuart Cash - You go into an asymmetric position. If the scheme's in surplus, the company gets no credit for anything above IAS 19 in the valuation. You might get away with lower contributions for future accrual but you wouldn't be able to take any money out. At that point, if there's not a big difference between the buyout number and where you are, there's a question of why not? For a trustee, I suppose it's much more interesting when your covenant is relatively weak.

Lesley Alexander - That's not necessarily in the trustees' hands - that's the problem. You could find that the sponsoring employer for the fund, which may be a very small company with a very weak covenant in relation to the overall size of the pension, is suddenly owned by a private equity fund that takes a significant interest in the pension fund because it's in a very healthy financial position. Even if the trustees want to buy out in that position, it can be extremely difficult to do so depending on the powers in the Trust Deed and rules - where the wind-up powers lay for example - or depending on the position of what remains of the sponsoring company where the trustees are being appointed from. A transaction can take place above the trustees' heads and the first thing they know about it is that they're sponsored by a private equity firm that has a significant interest in running pension funds or supposedly purportedly buying out those benefits.

Jonathan Clarke - At the same time, the trustees are likely to be replaced. That's where the regulator kicks in. It's getting back to the point made earlier about making sure you've got the right competence in terms of your advisors, and so on, to be able to evaluate these issues.

Nicholas Dunbar, Editor, Life & Pensions

Lesley Alexander, Group pensions manager, EMI

David Archer, Director, Pitmans Trustees

Stuart Cash, Managing director, Goldman Sachs

Nigel Casson, General manager, Invensys Pension Scheme

Jonathan Clarke, Independent pension trustee and chairman of RHM Pension Scheme Investment Committees

Terry Monk, Director, Independent Trustee Services

Jerry Moriarty, Director of policy, Irish Association of Pension Funds.