By Ryan McGlothlin
P-Solve USA
Published in Finance Monthly
Buyers of companies that sponsor defined benefit pension plans need to fully understand the nature of the liability that is associated with such plans. In many cases, the pension plan can represent the largest financial risk a company has. Proper due diligence pre-acquisition and prudent risk management post-transaction can therefore add value, or at least prevent significant value destruction, an all-too-common scenario.
There are two primary pre-transaction tasks for buyers of companies with defined benefit plans, both of which are often done improperly or even largely ignored:
1) Fully understanding the risks that they are assuming when buying the company.
2) Formulating a plan for how to proactively mitigate such risks post-transaction.
For example, there have been many acquisitions, particularly by private equity firms over the past decade, where poor management of the pension plan post-acquisition has led to significantly reduced valuations later. In some cases, such weak management of this area has closed the door to exiting a deal altogether.
It is normal practice of course for the buyer of a company with a defined benefit pension plan to engage professionals to conduct due diligence on the plan. This is often conducted as part of a larger due diligence assignment that may cover all employee benefits, corporate insurance coverage, accounting practices and other issues. The focus of this due diligence is typically to determine whether there should be a purchase price adjustment on the target due to the pension plan. Future risks are therefore often only peripherally addressed.
Instead, a pension due diligence checklist that should be followed in order to prevent such value-destroying outcomes looks like this:
1) Quantify the size of the pension plan relative to the enterprise value of the target and new combined entity (if a merger).
2) Quantify the full economic value of the pension liabilities, not just the actuarial or accounting value. NOTE: there are several ways to value liabilities – the buyer needs to understand all of them.
3) Model the risk of the plan on a forward-looking basis: understand the potential impact of various market scenarios on balance sheet, cash flow and income statement.
4) Model potential impact of changes to asset allocation.
5) Identify material actuarial or other plan assumptions to ensure that they are reasonable.
6) Understand the full economic cost of carry for the pension plan and compare to using an alternative source of financing (such as debt).
Historically, insufficient focus has been placed on the forward-looking risk of the plan and on educating the buyer as to how this risk can be managed. Proper due diligence upfront and the creation of a post-transaction pension action plan can prevent significant value destruction for buyers. Below are some concrete examples of how risk can be identified and understood, and how it can be managed to create value.
Pre-Transaction Risk Analysis/Due Diligence
Pension liabilities are equivalent, economically, to long-term debt, and pension plan deficits are accounted for as such under both US and international accounting standards. If a pension plan has a $20m pension deficit, then the sponsoring company’s equity value is reduced by at least $20m, in the same way that it would be with $20m in bank debt.
But it is extremely important how you get to the deficit, as one $20m deficit is not equivalent to another due to the nature of the pension plan: open vs. frozen, plan design features, asset allocation, etc. These differences as well as the potential financial volatility that can result from the pension plan are often poorly understood by company buyers and their advisors.
For example, a company might be being sold for $300m in equity value with another $100m in long-term debt and $20m in unfunded pension liabilities. Assume in one situation (Plan A below) the pension plan is large relative to the company and in the other (Plan B), much more manageable:
Even though Plan A would be considered healthier due to its higher funding level, it poses a significantly greater risk to the health of the company than does Plan B. If we assume that these plans are both invested in a traditional mix of equities and bonds (60% equities, 40% bonds) and that the liability duration (sensitivity to changes in long-term interest rates) is 12 years for both plans, then we can see what happens if the equity markets fall 10% and long-term interest rates fall by 100 basis points:
Plan A has impacted the company’s balance sheet much more significantly than Plan B. If we make a (highly simplified) assumption that pension deficits need to be amortized over 7 years, then when each plan had a $20m deficit, expected (pre-tax) cash contributions were approximately $2.9m per year for both Plans A and B. After the markets move, then Plan A would require contributions of $7.9m per year and Plan B $4.4m per year.
Clearly, the reverse of the above is also possible: market conditions can improve, reducing or eliminating a pension deficit. But the impact of markets not cooperating is in most cases much worse than the benefit of the deficit shrinking or a surplus appearing. Companies do not increase in value significantly because they have pension surpluses (as IRS rules prevent companies from accruing value in this way), but they will definitely be worth less when deficits increase. This sensitivity is especially acute in transactions where there is already significant financial leverage and a focus on free cash flow.
Companies with pension liabilities that are large relative to the company (as with Plan A above) should be valued less than those with smaller relative liabilities, even if the deficit at the time of sale is the same.
One methodology that can be used to estimate this value differential is to calculate the pension liability on a basis consistent with what would be used to terminate the pension plan, and then to use the resulting deficit as the purchase price discount. This is the true economic value of pension liabilities as it represents the amount required to fully and completely settle the liability and remove it from the plan sponsor’s balance sheet. Every pension plan sponsor should know what their economic liability value is.
Pension liabilities calculated on this basis will typically be 5-20% higher than what is shown on the balance sheet. This would change our calculation above to:
So the company with Plan A should be worth $15m less ($42m – $27m), all else equal, than the company with Plan B under this scenario.
Buyers should spend time modeling and stress-testing how the pension plan will respond to various market scenarios. But they are also advised to invest the time to understand the various actuarial methodologies for calculating pension liabilities as different ones are used to calculate the impact on balance sheet, income statement and cash flow as well as if the plan is ongoing or being terminated. Being “fully funded” on an actuarial basis may equate to a large deficit on an economic basis. Caveat emptor.
Post-Transaction Risk Management
Pension plans also represent an opportunity for a buyer to add value post-transaction by adjusting the plan’s asset allocation and funding policy. Traditionally, pension plans have been invested aggressively as plan sponsors have tried to use high returns from equities to reduce the amount of money that they have to contribute to the plan. This policy worked well in the 1980s and 1990s, but has largely failed in the past decade.
A buyer taking on a pension plan with a traditional asset allocation can add value immediately by reducing investment risk in the plan. This is accomplished by shifting out of assets that do not match the pension liabilities (such as equities) and into assets that do (long-term bonds). Taken to the extreme, a plan sponsor can eliminate the vast majority of investment risk from a plan, leaving the deficit to be amortized like normal debt. Removing the risk means that the discount a buyer (or the stock market) would need to place on the company due to the uncertainty of having a significant pension plan is reduced or eliminated.
Here’s an example: we can compare the impact of a 10% fall in the equity markets and 100 basis point reduction in long-term interest rates on Plan A and Plan B again, but this time post-transaction, with Plan A having moved its asset allocation into 100% liability-matching bonds and Plan B having stayed with 60% equities:
We calculated above that the purchase price discount for Plan A might be $42m if valued on a termination basis and $27m for Plan B. This is $22m and $7m, respectively, greater than the deficit shown on the balance sheet and is reflective of the risk embedded in the plans. However, if a plan is de-risked through asset-allocation, then the discount applied should be much less, and potentially no more than the deficit that is reflected on the balance sheet. In the case of a company sponsoring Plan A, this would add $22m of equity value through a simple, virtually costless change to pension asset allocation.
Unfortunately, there are very few examples of buyers making these kinds of decisions, and too often value is destroyed by buyers continuing to pursue high-risk pension investment strategies and by not properly accounting for the risk that they are assuming when buying a company with a defined benefit pension plan. So pay attention to proper due diligence upfront as well as develop a post-transaction pension action plan. The return on the time and money spent on this work pre-transaction can be exceptionally high.
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About the Author:
Ryan McGlothlin is a Managing Director of P-Solve, which provides strategic actuarial and investment advisory services to retirement plans in the US and UK. He has extensive experience advising companies on pension plans within a corporate finance context. Visit his website www.psolve.com.