A Practical Guide to Private Equity Transactions
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Conclusion
(d) the plan should enable Newco to offer sufciently attractive payouts to
ensure that the total reward is competitive within the marketplace, and
creates an appropriate incentive to drive the business forward; and
(e) the arrangements should t with the other components of the employees’
remuneration package.
5.4 Issues on exit
On the sale of Newco, a key issue to be addressed is that any potential buyer
will want to ensure that it can obtain 100 per cent of the share capital. The
smaller number of employees who typically participate in an incentive scheme
in a private equity context means that the logistics for the delivery of any option
shares (in return for the net proceeds from sale) is often relatively straightfor-
ward. Nevertheless, it is important to ensure that drag along provisions are
carefully drafted so as to capture any shares that may be issued pursuant to
pre-existing options.
23
As options are a right to acquire shares, any potential
buyer on a sale will consider them with great care. The risks of not adequately
dealing with options are at best poor employee relations, and at worst unex-
pected minority shareholders. This should not be an issue for incentive plans
where employees already hold shares at the time of exit.
Any option documentation entered into by participants should allow all
options to become exercisable on a sale of Newco. In addition, specic provi-
sions in the option documentation may be included whereby the option holders
are given the opportunity to exchange their existing options for options over
shares in the acquiring company.
When a company lists, it is usual for new incentive arrangements to be put
in place to motivate and retain employees following the listing. These must
comply with regulatory requirements, and address institutional investors’ con-
cerns. It may be that consideration is given to rolling over existing awards (i.e.
awards granted prior to listing) into a new plan, although this is unusual.
Given the fact that equity incentives are now fairly commonplace, they
should not, if properly implemented, cause any issues to the buyer on an exit,
or to the broker on a listing. However, care is needed at the time of imple-
mentation to ensure that a successful exit will not be hindered, and that the
participants in the scheme will not have a disproportionate level of inuence
at the time of exit.
6 Conclusion
The negotiation of the service agreements for management will often be an
emotive and difcult area, but it is essential that adequate protection is pro-
vided both to the managers and to Newco. The complexities of employment
23 See further chapter 5, section 4.13.
228
Employment-related issues
law mean that specialist input must always be sought; however, it is not the
case that the service agreements can be negotiated in isolation from the other
investment documents. Even if the key commercial terms are reasonably clear,
minor nuances in the drafting can have signicant implications for the over-
all balance of power, or the commercial outcome on any departure. The law-
yer drafting the investment agreement and articles of association must work
closely with the employment specialist to ensure that the documents sit neatly
together. As we will see in chapter 11, they must also work closely together in
the event that a decision is ultimately reached to dismiss a manager.
Share-based incentives also have a key role to play in the private equity
arena. The challenge is to implement creative arrangements to ensure that the
competing interests of the investors, the senior managers and the participants
are effectively aligned, such that the participants have a clear line of sight
on growing the business through to an exit event. When implementing incen-
tive arrangements for individuals outside the senior management team, the tax
treatment of any particular proposal will be key, and care is needed to ensure
that potential pitfalls on departure of a manager or ultimate exit are avoided.
A properly structured incentive scheme, combined with comprehensive
and carefully documented employment terms, can bring signicant value to
bear for the benet of all parties at the time of exit. It is essential, however, to
ensure that oversight on the part of any of the lawyers will not result in any
particular individual having an inappropriate reward or bargaining position;
in that respect, the interests of the lawyers representing the investors and the
management team respectively are often more aligned than rst appears.
229
8
Pensions
1 Introduction
In this chapter, we look at the complexities that arise where a transaction
involves a UK pension scheme. The chapter begins by explaining some basic
concepts and terminology relating to UK pension schemes. For practitioners
who do not encounter issues surrounding pension schemes often, the different
types of scheme and regulatory framework can be intimidating, but they must
be appreciated so that the issues that arise where a pension scheme is involved
can be properly understood and addressed with the minimum impact on cost
and timetable.
The ‘moral hazard’ legislation is also explained in some detail, as this is fre-
quently encountered and has signicant implications in the private equity arena.
The chapter concludes with an overview of the specic issues that arise in the
context of private equity deals on acquisition, during ownership and on exit.
2 Key issues and principles
2.1 Types of pension scheme
There are two basic types of pension scheme:
(a) ‘Dened contribution’ schemes, where the contributions to be paid to the
scheme by both the members (employees) and the employers are dened
(typically, as a percentage of salary). A notional member’s account is main-
tained for each member. The benets provided are those which can be pur-
chased (usually from an insurance company) with the member’s account at
the time the pension becomes payable. The member takes all of the risks, for
example in relation to investment performance, ination and annuity rates.
(b) ‘Dened benet’ schemes, where the benets to be provided to members
are dened. These are typically ‘nal salary’ schemes where the benets
are calculated by reference to pensionable salary at or shortly before retire-
ment (or earlier leaving date), e.g. one-sixtieth of pensionable salary for
each year of scheme membership. The member knows what the benets
230
Pensions
will be because they are dened; however, the costs of securing those
benets are unknown. Usually, dened benet schemes are ‘balance of
cost’ schemes. This means that members contribute at a xed rate (some-
times nil), and the employers pay the balance of the costs. This means the
employers take all of the risks on investment performance, annuity rates,
and so on. Sometimes, these schemes are ‘shared cost’, where the members
and the employers share the costs in a xed proportion, typically 60 per
cent employer, 40 per cent members.
There are some hybrid benet designs. The most common are:
(a) ‘career average revalued earnings’ (often referred to as CARE), where each
year’s benets are based on salary during that year; and
(b) ‘cash balance’: this looks more like a dened contribution scheme.
However, it is a risk-sharing arrangement because the employer promises
a particular cash balance at normal retirement date which is then used to
purchase an annuity. The employer bears the investment risks. The mem-
bers bear the annuity rate risks.
The most material risks for private equity investors relate to dened benet
schemes. The issues discussed in this chapter, therefore, primarily relate to
these schemes.
2.2 Pension scheme funding
There are a number of different ways that the funding of dened benet pen-
sion schemes can be measured. This often causes confusion. The different
methods and their usual application are as follows:
(a) IAS19 (or FRS17/IFRS) basis. This is the accounting basis which companies
are required to adopt to account for their pension schemes in their accounts.
It is mandatory for accounts in respect of accounting periods commencing
on or after 1 January 2005 (listed companies must use IAS19; unlisted com-
panies can choose between FRS17 and IAS19). Prior to that, during a transi-
tional period, the funding level on an IFRS basis was mentioned in the notes
to the accounts, but did not ow into the balance sheet. For the purpose of
this measure, regardless of the assets in which the scheme is invested, the
liabilities of the scheme are discounted by reference to AA corporate bonds.
This can lead to some anomalous results. For example, in March 2004, the
AA corporate bond rate was particularly low. As a result, many companies
had signicant accounting decits even though the scheme was well funded
on a scheme- specic funding basis (see (b) below). In contrast, in December
2008, AA corporate bond rates were particularly high because of the dif-
culty of companies, particularly nancial institutions, obtaining debt. As a
result, in many cases the accounting position will not have been as bleak as
the funding position. The accounting funding measure has no relevance for
the actual funding of a scheme.
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Key issues and principles
(b) Scheme specic funding basis. This is the basis used to determine the
contributions that are payable to a dened benet pension scheme. It is
based on actuarial methods and assumptions adopted for the scheme in
accordance with the Pensions Act 2004. The assumptions used vary from
one scheme to another and from one actuarial valuation to another which,
together with the scheme and investment experience in the intervening
period, can mean that the funding level can vary greatly from one valuation
date to another. Although the scheme specic funding basis arises under
the Pensions Act 2004, how it applies in relation to individual schemes
depends on the scheme’s rules. Usually, the methods and assumptions are
chosen by the trustees with the agreement of the employer, but this can
vary. It is essential to review a scheme’s rules to understand a scheme’s
balance of power. If the trustees have unilateral power to x the contribu-
tion rate, negotiations with them on all matters will be very different than
for schemes where the power is balanced between the employer and the
trustees. The process for setting the contribution date is described in more
detail below.
(c) Buyout basis. This is the cost of securing the benets with an insurance
company by purchasing annuities and deferred annuities. This generally
leads to a much greater decit for a scheme than any other basis. This basis
is used when liabilities are actually being bought out, and for calculating
‘section 75 debts’.
1
It also may be relevant if the Pensions Regulator is
considering a clearance application where there is corporate activity which
may cause material detriment to the scheme, or where it is more uncertain
that the employer will continue as a going concern.
2
(d) PPF buyout basis. This is a concept introduced by the Pensions Act 2004.
It is a buyout basis but only for those benets that are covered by the UK
Pension Protection Fund (PPF) (see further section 3.1 below). This measure
is used to determine the PPF levy which a scheme has to pay. It may also be
relevant if the Pensions Regulator is considering a clearance application.
3
The trustees of a dened benet scheme are required to obtain actuarial valua-
tions of their scheme annually, or tri-annually if actuarial reports are obtained
for the intervening years.
4
Typically, valuations are carried out tri-annually,
although trustees often have power to carry them out more often should they
decide to do so. The results of the actuarial valuation are then used to deter-
mine the employer’s contribution obligations.
It is a key piece of due diligence
5
to establish who has power to set the contri-
bution rate. If the trustees have a unilateral power, then they may seek to increase
1 See section 2.3 below.
2 See ‘moral hazard’ in section 3 below.
3 See ‘moral hazard’ in section 3 below.
4 Section 224 of the Pensions Act 2004.
5 For due diligence generally, see chapter 2, section 4.
232
Pensions
and/or accelerate employer contribution obligations following a purchase by a pri-
vate equity house, particularly if the purchase is highly leveraged. The scheme’s
trust deed and rules govern who has power to set employer contributions, but this
is subject to overriding provisions of the Pension Act 2004.
6
Individual scheme
requirements vary widely, but, typically, the power may be vested as shown in
Figure 8.1 (which shows the implications of the overriding provisions).
Where it is a joint power, the actual bargaining position between the trus-
tees and the employer will be inuenced by a number of factors, including
what other powers the trustees have under the trust deed and rules. Key pow-
ers under a trust deed and rules include the investment power (trustees typ-
ically have a wide investment power
7
) and the power to wind up the scheme
(trustees sometimes have a unilateral power). When a scheme winding up
is commenced, a statutory debt will be triggered equal to the buyout decit
of the scheme (see further section 2.3 below). Although it would be a dra-
conian step for trustees to trigger a winding up, if they have power to do
so it can have a signicant inuence on the bargaining position in funding
discussions.
Under the Pensions Act 2004, the trustees (having consulted the employer
or with the consent of the employer, depending on the scheme provisions, as
summarised above) must:
Trust Deed and RulesTaking account of the
Pensions Act 2004
Unilateral trustee power, with no power for the
employer to suspend or vary contributions
Unilateral trustee power but the
trustees must consult the
employer
Unilateral trustee power, with power for the
employer to suspend or vary contributions
Joint trustee/ employer power
Actuary power
Joint trustee/ employer power,
but the actuary must certify that
the agreed amounts are not less
than what he would have
specified
Figure 8.1 Power to set contributions
6 Sections 38–57 of the Pensions Act 2004.
7 This is given to trustees under most trust deeds and also under section 35 of the Pensions Act
1995, subject to express restrictions in the trust deed which are relatively unusual.
233
Key issues and principles
(a) decide on the methods and assumptions used to calculate the scheme’s
‘technical provisions’
8
(technical provisions, essentially, means the value
of the scheme’s liabilities);
(b) prepare a ‘statement of funding principles’,
9
which is a document that sets
out those methods and assumptions, and the period within which any def-
icit is to be remedied;
(c) prepare a ‘recovery plan’,
10
which is the document that sets out how any
decit is to be remedied; and
(d) prepare a ‘schedule of contributions’,
11
which is the document setting out
the contributions the employer is required to pay, including those covered
by the recovery plan and those required to meet future service benets.
All of these must be in place within fteen months of the effective date of
the actuarial valuation, although the Pensions Regulator has power to extend
this (and does so in practice where the trustees must reach agreement with the
employer, and it seems that this will be obtained if further time is available).
If the trustees fail to put these documents in place within the required time-
scale (typically, because they have been unable to obtain employer agreement,
or if the actuary cannot give any certication which he is required to give),
the Pensions Regulator has wide power to impose contribution rates and other
matters. The Pensions Regulator has been clear in its guidance that it does not
expect this to occur often.
The Pensions Regulator has issued guidance to assist trustees and employ-
ers to implement the statutory funding regime. It places signicant emphasis
on the strength of the employer covenant, which is dened as the ability and
willingness of an employer to meet its funding obligations under the scheme.
Trustees are very likely to take the view that a highly leveraged purchase
will materially weaken the strength of the employer covenant, because the
employer is arguably both less able and less willing to meet its obligations.
With any proposed transaction, it is essential to engage with trustees early on
in the process to reassure them where possible, and to obtain a clear under-
standing of whether they are likely to take steps that could lead to increased or
accelerated funding requirements.
2.3 Section 75 debts
A statutory debt is triggered under section 75 of the Pensions Act 1995 (com-
monly referred to as a ‘section 75 debt’):
(a) when a scheme winds up (as referred to in the context of trustee powers
above), in which case a debt is payable by the employer (or a proportion of
8 Section 222 of the Pensions Act 2004.
9 Section 223 of the Pensions Act 2004.
10 Section 226 of the Pensions Act 2004.
11 Section 227 of the Pensions Act 2004.
234
Pensions
the debt by each of the employers, if there is more than one) equal to the
scheme decit calculated on a buyout basis;
12
and
(b) where the scheme is a multi-employer scheme, if one of those employers
ceases to have any employees who are active members of the scheme at a
time when there are still active members of the scheme employed by other
employers (called “an employer cessation event”), in which case a debt is
triggered on the exiting employer (called the ‘cessation employer’) equal
to a proportion of the decit of the whole scheme, again calculated on a
buyout basis, on the exit date. This is often of relevance in private equity
transactions, as a section 75 debt is often triggered on the separation of a
non-core business from its parent group.
There are regulations which set out further details in relation to the calculation
of the debt on a ‘cessation employer’. With effect from 6 April 2008, these reg-
ulations were materially amended, in particular to include a statutory mech-
anism whereby the amount of the debt payable by an exiting employer may be
reduced. As issues can still relate to events which took place before 6 April
2008, both regimes are discussed below. In respect of any transactions being
negotiated now, clearly only the post 6 April 2008 regime will be relevant.
(a) Pre 6 April 2008
If an employer cessation event occurred before 6 April 2008, then the
Occupational Pension Schemes (Employer Debt) Regulations 2005
13
(the ‘2005
Regulations’) will apply, regardless of when any action may be taken to deal
with the debt.
Under the 2005 Regulations, there are two ways that the debt payable by
the exiting employer can be reduced:
(a) Apportionment under the scheme provisions.
14
A scheme can have a rule
allowing a section 75 debt to be apportioned in a way that is different from
the statutory formula. However:
(i) the introduction of a new apportionment rule will usually be a ‘Type
A event’ and therefore a potential trigger for the Pensions Regulator’s
moral hazard powers (see further section 3 below); and
(ii) any use of an apportionment power to reallocate a debt after the date
that the employer cessation event occurred is automatically a Type
A event. It will also often be regarded as a ‘compromise agreement’,
whereby the trustees are regarded as having agreed to compromise a
section 75 debt owing to the scheme, which again can be a trigger for
12 For the meaning of ‘buyout basis’, see section 2.2(c) above.
13 SI 2005/678.
14 Regulation 6 of the Occupational Pension Schemes (Employer Debt) Regulations 2005 (SI
2005/678) provides that the employer’s ‘share of the difference’ (which is the debt due) can be
the amount due under a scheme provision.
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Key issues and principles
the Pensions Regulator’s moral hazard powers. Further, the scheme
may cease to be eligible for the Pension Protection Fund (see section
3.1 below). As a result of these implications, it would be very difcult
indeed for the trustees to agree to apportion a section 75 debt which
was triggered by a cessation event before 6 April 2008.
(b) Approved withdrawal arrangement (AWA).
15
Under an AWA, the debt pay-
able by the cessation employer is reduced and the balance is guaranteed
(the guarantor can be another scheme employer, or a person connected
with the cessation employer or with another employer). An AWA must be
approved by the Pensions Regulator, which approval can only be given
where the debt is more likely to be paid if the AWA is approved. In prac-
tice, this can make it difcult for an AWA to be implemented, unless cir-
cumstances are such that the cessation employer is in fact unable to pay the
debt and was unable to do so on the date it ceased participating.
(b) Post 6 April 2008
If an employer cessation event occurs on or after 6 April 2008, the 2005
Regulations as amended by the Occupational Pension Schemes (Employer Debt
and Miscellaneous Amendments) Regulations 2008 (the ‘2008 Regulations’)
16
will apply. Under the 2008 Regulations, there are now four ways that a section
75 debt payable by a cessation employer can be reduced. These are:
(a) a scheme apportionment arrangement;
(b) a regulated apportionment arrangement;
(c) a withdrawal arrangement; or
(d) an approved withdrawal arrangement.
Prior to April 2008, the lack of a meaningful statutory mechanism for redu-
cing the amount of a section 75 debt payable by a cessation employer often
acted as a roadblock on transactions where a section 75 debt would have been
triggered. Particularly given that section 75 debts are calculated on a buyout
basis, payment of the full debt was often not commercially viable. Although
all of the new statutory mechanisms require trustees’ consent, in practice the
existence of these arrangements should mean it is possible, in some circum-
stances, to make arrangements whereby a reduced section 75 debt is payable to
facilitate transactions.
(i) Scheme apportionment arrangements A scheme apportionment arrange-
ment is an arrangement under the scheme rules whereby the cessation employer
pays a lower share of the decit than would (in the absence of the arrangement)
have been the case, and whereby all or part of the amount which would have
15 Regulations 7, 7A and 7B of, and Schedule 1A to, the Occupational Pension Schemes
(Employer Debt) Regulations 2005 (SI 2005/678).
16 SI 2008/731.
236
Pensions
been the cessation employer’s share of the decit is apportioned between one
or more of the remaining employers. There is no requirement for the reap-
portioned share actually to be paid by a particular date. The key restriction
on scheme apportionment arrangements is that the trustees must agree to the
arrangements, and can only do so if the ‘funding test’ is met.
Broadly, the funding test requires the trustees to be reasonably satised that:
(a) the remaining employers will be able to meet the payments which are due
under the scheme’s schedule of contributions (taking into account any
changes required under the scheme apportionment arrangement); and
(b) the effect of the scheme apportionment arrangement will not be to affect
adversely the security of scheme benets as a result of any:
material change in legal, demographic or economic circumstances (as •
described in scheme funding legislation) that would justify a change to
the method or assumptions used for the scheme’s ‘technical provisions’
used for assessing scheme funding (see further section 2.2 above); or
material revision to any existing recovery plan under which a scheme’s •
decit is being paid off.
The introduction or use of an apportionment rule would be a potential Type A
event triggering the Pensions Regulator’s moral hazard powers (see section 3
below).
(ii) Regulated apportionment arrangements Regulated apportionment arrange-
ments are only relevant in the case of schemes that are likely to enter the
Pension Protection Fund
17
as a result of the scheme employer’s insolvency.
There is no funding test for a regulated apportionment arrangement,
but instead there is a requirement that it must be approved by the Pensions
Regulator, and that the board of the Pension Protection Fund must not object
to the arrangement.
(iii) Withdrawal arrangements A withdrawal arrangement under the 2008
Regulations is similar to an approved withdrawal arrangement under the 2005
Regulations (see above), in that it is an agreement between the scheme trustees,
the exiting employer and a guarantor. However, with a withdrawal arrange-
ment under the 2008 Regulations, the amount of the section 75 debt payable by
the cessation employer is determined by reference to the decit calculated on
the scheme specic funding basis, rather than on a buyout basis.
18
Therefore,
the amount of the debt should be much less. It may be paid in instalments.
The guarantor must provide a guarantee to pay an amount described as
‘amount B’. There are two alternative methods which may be used for calculat-
ing amount B. The rst is the section 75 debt which would have been payable
had the cessation employer’s debt been triggered at the ‘guarantee time’ (see
17 For more on the Pension Protection Fund, see section 3.1 below.
18 The Occupational Pension Scheme (Employer Debt) Regulations, Regulation 6C and
Schedule 1A. For the meaning of ‘scheme specic funding basis’, see section 2.2 above.