Episode 5: Private equity and their love/hate relationship with defined benefit pensions

Episode 5: Transcript

Raj Mody:

Hello and welcome to this episode of Pensions Cast, a podcast where we discuss topical pension issues being faced by companies, pension scheme trustees and pension scheme members. I'm Raj Modi, a partner at PwC, working with our clients here in the UK and around the world on a wide range of pension issues. Really pleased to have with me in the studio today a number of guests. I'm joined today by Steve Kirkpatrick, who is head of pensions in the UK for PwC and a lead M&A adviser. Matt Cooper, who leads PwC’s advice to pension scheme sponsors and trustees on a different kind of transaction, where you're looking to transfer defined benefit pension schemes into different types of vehicles, consolidators, SuperFunds, other kinds of funding solutions.

And also delighted to welcome Michael Clark, Chief Executive Officer of the Pension SuperFund, which is lining up to be one of those consolidator options in the market. Welcome to you all. We were hoping today to explore the love-hate relationship, if you like, or the Jekyll and Hyde perspectives, which we think they're all around defined benefit pension liabilities and private equity in particular, private equity interest or not in defined benefit pension liabilities. I'm going to start, Steve, with your angle, which is private equity’s role when it comes to trying to do deals with companies, typically buying companies that have defined benefit pension liabilities. I think it's fair to say M&A activity in that kind of space increased quite sharply in 2021. I'm sure you'll go into why. At the same time, I think the existence of DB liabilities in an M&A situation can cause some problems for private equity.

I think that's fair to say as well. So tell us, give us a bit more context. Tell us about that.

Steve Kirkpatrick:

Yes. Hi, Raj. Thanks for having me. Yeah, look, in terms of a love-hate relationship, my experience working with PE guys is probably more on that on the hate side, I have to say, when they're buying and selling companies. So, no doubt about it. 2021 was a big year for M&A. Lots of factors driving that. So money was cheap, interest rates were low. Companies had a lot of change in the agenda. Covid's meant that businesses need to pivot their strategies. And fundamentally, growth has been low. So, if you want to grow in organic growth, inorganic growth’s been a good option and particularly for private equity. Asset prices have been quite low. Stock markets took a hit. That meant it was reasonably cheap to buy it by businesses over 2021. So you saw private equity really at the fore of buying and selling.

Raj:

And so drill down a level into the problems of the pension scheme itself.

Steve:

Yeah, sure. So there are a number of things. I mean, fundamentally my experience of private equities is what they're looking for to some extent is certainty around their investment. They want to build conviction about the investment case and defined benefit pensions and bring, by definition, lots of uncertainty. Now there's particular uncertainty around how you might price a DB pension scheme into a transaction. Lots of DB schemes have shortfalls. There's no sort of consensus really in a transaction about how that shortfall should be priced into business valuation. So that can cause difficulties in negotiations. A really fundamental uncertainty for private equity is that of a leveraged deal. Lots of secured debt is going to affect the covenant for the pension plan and it's unclear at the time the private equity house is trying to make that investment, very often it's unclear how the pension scheme is going to react. So that makes it hard for them to model. And then we have all the changes. I mean, I won't go into it, but all the changes, Pensions Act and what not with the regulatory changes around things. So, it just creates uncertainty and that is hard for the PE guys.

Raj:

Yeah. I wouldn't say it's hard to predict how the pension scheme will react. Let me just bring Michael in on this. I think you specifically mean the pension scheme trustees as well as the as the fiduciaries. They're being responsible for the pension schemes and in fact, dealing with what you referred to the new regulation in the shape of the Pensions Schemes Act, which came in in 2021. I mean, Michael, you, notwithstanding your current role, you've also seen this through different vantage points, including being in-house in a corporate. But what's your perspective on DB schemes and the management issues that go with them?

Michael Clark:

Well, thank you for inviting me. I think just building on what Steve said around how sponsors perceive pension schemes, you look at the cost of just managing it in terms of resources and management time, you know, that's becoming disproportionate relative to managing other aspects of the business or indeed the balance sheet. You know, if you think that so much corporate activity is now being outsourced to third parties, for whom it's a core competence, and they deliver the benefits of scale and continuous improvement, more sponsors are looking at should they be managing their own pension scheme.

Raj:

Yeah. So between the two of you so far, you're painting, as you said, Steve, a reasonably good hate relationship when it comes to at least private equity and M&A situations and DB liabilities. Just before we move into, ‘is there another perspective around all of this?’, we said we weren't going loads into the Pension Schemes Act, but that does bring with it criminal offenses. So that's more on people's minds. What about the economic situation just any more to say on that in terms of you talked briefly about valuations and deficits. Is it worth just touching on that?

Steve:

Yeah, I think it's worth saying that things have changed quite a lot probably in the last six months or so. So obviously the macroeconomic environment is very different. Rates have shot up, interest rates have shot up, so has inflation. Net-net, what I'm saying is that schemes that didn't hedge hard are seeing quite big improvements to their funding levels actually. So versus some of the pain that was in the system in 2021, a lot of pension schemes are clearly better funded. Having said that, for private equity, where the way those transactions happen is all around debt and leveraged secured, debt at the price of that debt has gone up. So what I'm seeing with the transactions I'm working on is the financial position of the pension scheme is better, but I'm seeing a higher level of concern from pension trustees about the interest costs that businesses will face and what that will mean for the covenant sort of over time. So I think the environment has changed and that's changed the conversation a little bit. I'm seeing at the moment.

Raj:

Matt, I'm was going to come to you actually, Matt, because that point Steve said about the fund, while there were issues like interest cost, interest costs being higher, the financial health of pension schemes, actually, if anything lately has improved for various reasons you can go into. I'm just wondering as a bridge to get into the other side of the relationship with DB liabilities, how does that affect the kind of market you look at when it comes to getting these schemes into, you know, third party type vehicles, consolidators or otherwise?

Matt Cooper:

Well, I really do agree with that point that the conversation that I am having with pension scheme trustees and sponsors is really different to the conversations we were having six or twelve months ago. We have seen these quite dramatic changes in financial markets. Some, as Steve said, significant increases in interest rates, inflation as well. And that's another key factor in the valuation of pension liabilities. But it's really, really specific to the individual pension schemes and the asset strategy that they were running prior to these economic changes coming into effect. Those schemes that were actually quite under hedged, they have probably seen the biggest improvement in funding level and schemes that by the nature of their benefits have caps on how those benefits increase relative to inflation, maybe have not been as impacted by the sort of the rise in inflation we've seen over the first half of the year. But I agree, Raj, that for the majority of cases, pension schemes are in a much better funding position than they were previously and that if anything, is creating more opportunity to explore these different sorts of solution.

Raj:

So let's look at that in more detail. I mean, it's worth saying that our own pensions funding index, where we track the aggregate funding status of the universe of UK pension schemes, just over 5000 current defined benefit pension schemes, also shows a really significant surplus. Now you need to be careful with aggregate numbers because obviously there's a risk in that they'll still be some schemes in there clearly in deficit, but the majority, without question on the measures they use for themselves, are showing a surplus, sometimes a significantly healthy surplus. However, the Government has also made this point as well, that 5000 pension schemes, separate entities, all with their own governance. Is that really the most optimal model? The Government's talked about consolidation of the market you know into fewer larger schemes. So Michael, that does segue, I think hopefully neatly into what you and the SuperFund or the SuperFund-style consolidator market is all about. Can you just elaborate on that a bit, please? Why has this really come about as a new market relative to the plain vanilla style of buy-in and buy-out that we've seen for years and years?

Michael:

I suppose like any new product coming to the market, there's a demand for it. We see a gap in the market in terms of solutions. We think the consolidators will bring a more flexible alternative to buyout and bringing better value for money, with high levels of governance. We see that the regulator has set a high bar for us in terms of financial securities, so they've mandated that central to all we do is this 99% probability of being fully funded over five years. It's a high bar; it's equivalent to what we see insurers having to meet.

We have to adhere to very high standards of governance and indeed, the regulator has told us so. They expect us to be setting best practice in terms of governance and of course, through consolidation, we offer a number of schemes, wider access to the investment universe and the synergies that come with that perhaps and this is to remain with our model.

Perhaps the one thing that we are saying is that the upside that we can actually create from this consolidation will share with members in the form of a member bonus, which I think brings us back to what we had twenty years ago in the industry, where that was something that people aspired to and we hope to bring that back.

Raj:

Yeah. And in fact, the rates of inflation we're seeing at the moment is making some corporates - even well-funded schemes - think about discretionary pension increases, which was a feature of the 1990s. But we've not really seen that since. Matt, Michael's said there's demand in the market and outlined features of what appears to be a really viable option as an alternative for pension schemes. Slightly unfair question perhaps, but why have there not been loads of transactions of this kind so far? And I'll have Michael come in on his point of view about that in a second. But your first piece, Matt?

Matt:

Well, I think it is very fair to say that it has been a very long road to get to where we are. I remember writing a response to the Government consultation on consolidation back in 2018, which talked about the solutions. And here we are today still waiting on that first SuperFund transaction. I though take huge comfort from the rigour and the time that the regulator has spent creating this regime and building this trust in the industry.

This is pensions, these are people's livelihoods in retirement. We need to hold providers to a very high bar and the industry will look for proof of concept. It will look for trust in order to allow these transactions to take place. And initially in what is a new industry in its infancy, that trust will have to come from a robust regulatory regime under which we can rely.

The Pensions Regulator itself has set a series of gateway tests to assess ultimately if members will be better off in these new vehicles. The regulator requires pension scheme trustees and sponsors to go through a process where they will get effectively assessed and clearance on these transactions. And that in itself will create some initial challenges. You know, these haven't been done before advisory costs for the first transactions will be high. And it's not like the traditional buy-in / buyout market, which is a well-trodden path.

Also, a feature I'm seeing right now is it's hard for trustees and sponsors to make decisions in this level of market volatility. A number of my clients who I've been working with looking at SuperFunds have benefited from improvement in funding positions and now they're exploring other options as well.

That said, there are other schemes out there where, befor,e SuperFunds haven't looked like they would be an appropriate solution, but now their funding levels are coming to a state where they should be explored.

Raj:

So yeah. Michael, there's a lot that's to go over - why these deals are difficult to do. What do you think?

Michael:

Going back to your question in terms of why is it taking so long? I think one word, inertia. I do think that groupthink is endemic in the pensions industry. It's not a bad thing. I think it's helped us mitigate against some of the bad practices and it's really raised the level of professionalism. But at the same time, I think it's bred inefficiencies and if you think back to at the start, we were talking about private equity investors looking at the use of capital. They see us as very inefficient users of capital. Now, I'm not saying that's a bad thing. We have to protect member benefits. So we're not in the same frame of mind of that. But I suspect there are areas where we could do things better in terms of capital and this is one area where we really are looking to take a longer term perspective around the use of pension fund assets to actually release that surplus back to members.

We were talking about hedges earlier on, and I think one of the things that we've seen at this recent volatility is as shown how efficient or not people's hedges have been. We look at how we account for them in valuations. We're very prescriptive, you know, to the days when we think of long term real assets providing A or B in indirect but a good long term hedge for inflation. So, you know, we've seen some volatility that shouldn't have been there simply because you couldn't hedge some of these risks.

Raj:

And just talking about capital, because I did want to bring this background, if possible, to that idea of capital that on the one hand, Steve's talked about private equity backed acquisitions being quite problematic when it comes to defined benefit pension liabilities. On the other hand, we're talking about providers with capital deliberately coming into this space, albeit because they think there's a play around the efficiencies of consolidation or whatever it might be. But I just want to bring that contrast out. So Matt, I think you've previously told me some statistics around the market. So certainly if we look back to 2020, this wasn't a very fulsome and popular market, maybe,certainly in terms of alternatives even to the types we've been talking about, alternatives to insurance and alternatives to consolidators. There was maybe one other - call it third party capital provider - out there that was interested in doing variations of deals like this. Now, in 2022, you're telling me that there are more than five quotes for this kind of business. How much capital is behind this kind of new industry?

Matt:

Well, I think this is a very fast growing space. And as you say, the number of providers looking to effectively put up capital to underwrite investment returns for pension schemes seems to be increasing every week. But based on the work we've done, that's around £2 billion of capital now pledged for these types of transactions. And that broadly equates to supporting £20 billion of pension scheme liabilities.

Raj:

Right? Because the £2 billion is just a buffer on top of the existing pension scheme asset and liability profile. So with £2 billion of extra buffer capital, you can touch quite a bit of the market in terms of pension liabilities. But if I just bring Michael in there because you're on the other side of this equation, whether that number is quite right or growing anyway, what type of return? Given all the difficulties that go with defined benefit liabilities. What type of return are people behind these types of organisations expecting?

Michael:

I would think within that £2 billion, we probably have to differentiate between the capital providers that back start-ups and we think of our own structure. And also, Clara, the other scheme you have capital providers are willing to invest in a start-up and I think that capital is more risk capital to set it up. Once you get up and running, you need a lot more capital to come in to support these deals. And I think that more vanilla capital, that's just looking to support these perhaps lower risk investments, the rates of return that are being offered there are quite likely to be much lower than the initial providers. I don't want to go into any particular detail, but my sense is that you could see similar rates of return on some of these assets in the insurance company and I think, though, that will be the assessment that the capital providers are making around this.

Raj:

Right. So that makes sense as a different kind of return or return expectation depending on where you are in the life cycle of these kinds of ideas. If you're at the more speculative end, you want a higher return. When you get to a more established process, you might get a more conventional return. Maybe just coming back. Michael, because we only touched on this briefly about the likelihood or viability of these solutions happening. Matt talked about the very careful regulatory assessments that are going on that concur with your experience?

Michael:

Absolutely. We've spent a lot of time and had a lot of regular engagement with the regulator. And as you can imagine, they are going through all of our constitutional documents, policies, in fine detail. And we have to answer a lot of questions and we have to demonstrate that we are meeting best practice. But the area of engagement that's really impressed me with the regulator is some of the strategic discussions we've had. They certainly see this as a large part of the pensions landscape and often they'll preface some of their comments about when consolidators get to scale, what is the landscape going to look like? What is the governance going to look like? So it's clear that they are thinking not just about individual schemes, but actually as the market develops.

Raj:

Interesting. So, Steve, as we're painting a picture of the future, let me bring you back in as it relates to M&A. We are at the early stages of this, but if we see a future where this is part of the regular landscape of the pensions industry, what happens to M&A? I mean, do you not just see, you know, why wouldn't companies even contemplating M&A or being an M&A target transfer their schemes to a consolidator? Do we see a rapid reduction from the 5000 DB schemes into a significantly smaller number? And does that completely change the way that M&A is done forever?

Steve:

Well, I can definitely see it becoming a big part of the conversation. So if you think about buying and selling a company, if you're on the sell side, if you're private equity, you're bringing a company to the market. I suppose the decision you've got to make there is, do you think that you will get a smaller price chip and selling the pension scheme with the business, if you like? Or is it worth removing the pension scheme from the balance sheet to try and get a better price for that company?

And the timing is going to be important there. How long will it take to get off the balance sheet? And really, it's a question of pricing. If schemes are better funded, PE guys might feel they can get the company away without a price chip. Having said that, like we talked about before, buyers don't like DB pension schemes because they bring lots of uncertainty. So I think there'll be that play there. And on the buy side, I can see private equity once they've picked up a company with a DB pension scheme and they're thinking about how to manage that pension scheme over the holding period that they have.
I can see them wanting to look at all options to add value. So I definitely see it as a part of the conversation.

Raj:

Yeah, it's fascinating as a number of us will all of us around the table have worked in pensions for a number of years and you think you've seen all the innovations you could see. But actually probably the next decade or two will be possibly the most innovative in the pensions industry that any of us have seen. So there's lots to look forward to there.

Well, look, thank you, Steve, Michael and Matt, for joining me for that discussion today. I hope you found that interesting listening on the other end of it. Please let us know your feedback as ever. Our contact details are in the show notes and we'll be very happy to get back to you personally. Please also let us know your ideas that you'd like to hear us discuss in future episodes. It's always nice to hear from the real world out there after we've done one of these tucked away in our soundproof studio. If you'd like to find out first, when future episodes of PensionsCast drop, then as they say, please subscribe on Apple Podcasts or Spotify. Please subscribe anyway. We're always keen to welcome a growing audience. Thank you for listening to Pensions Cast.

Goodbye for now.

Participants

• Raj Mody
• Michael Clark
  
• Steve Kirkpatrick
  
• Matt Cooper