A Practical Guide to Private Equity Transactions

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247

The Pensions Regulator and ‘moral hazard’

Figure 8.3 contrasts the key characteristics and tests in respect of the two

moral hazard powers.

3.4 Clearance

There is a clearance procedure under the Pensions Act 2004 whereby a person

can apply to the Pensions Regulator for conrmation that the Pensions Regulator

will not issue a contribution notice or, in theory at least, a nancial support dir-

ection on the applicant in respect of particular facts and circumstances which

are notied to the Pensions Regulator in the clearance application. Where it is

considered that there is or may be what is described as a ‘Type A event’, thought

should be given to seeking clearance from the Pensions Regulator.

The Pensions Regulator issued clearance guidance in April 2005, shortly

after the moral hazard powers came into force on 5 April 2005. It was clear

from this guidance, and is also clear from the Pensions Regulator’s behav-

iour, that the Pensions Regulator interpreted its moral hazard powers very

widely. The 2005 guidance categorised events into: (a) ‘Type A events’, being

events which are or may be nancially detrimental and of which the Pensions

Regulator would like to be notied, and in relation to which consideration

should be given to seeking clearance; (b) ‘Type B events’, which do not affect

the scheme and where clearance would not be appropriate; and (c) ‘Type C

events’, where the position is less clear.

The term ‘Type A event’ has now been widely adopted to describe any

event which will or may be prejudicial to a pension scheme. Type B events

and Type C events, on the other hand, are not used in practice; the Pensions

Regulator is only generally contacted in circumstances where there may be a

Type A event.

Although expressed to be illustrative only, the 2005 guidance set out con-

crete examples of events that the Pensions Regulator would regard as detri-

mental. In summary, these were:

Contribution Notices Financial Support Directions

Can be issued up to 6 years after an act or

omission

Can be issued 2 years after parties cease

to be associated or connected

Fault based – there must be an act or

omission

No fault – based only on financial

strength

Can be issued on individuals (including

directors)

Can only be issued on companies where

the scheme employer is a company

Requires an immediate contribution (up

to the buy-out deficit)

Requires financial support

Figure 8.3 Key features of contribution notices and ﬁnancial support directions

248

Pensions

(a) Change in priority. A change in the level of security given to credi-

tors where the scheme might receive a reduced dividend on insolvency.

The granting of security other than in respect of new money would be

regarded as detrimental if it affected more than 25 per cent of the assets

of the group or of the employer. Although there was effectively a ‘tickbox’

checklist of when the test would be satised, in practice it was often dif-

cult to assess whether there was a Type A event under this test in respect

of a group.

(b) Return of capital. A reduction in the overall assets of the employer

available to the scheme. A return of capital would be regarded as detri-

mental where a payment was made to an entity which could not be the

recipient of a contribution notice or a nancial support direction and the

amount involved was more than two times the average return over the

past three years, or where it would reduce dividend cover to less than 1.25

times (retained after tax prot, divided by the return of capital over the

period).

is a change in the persons against whom a contribution notice or nan-

cial support direction could be issued which was material. Such a change

would be material where it negatively affects the scheme employer’s credit

rating.

Under the 2005 guidance, an event was only a Type A event if the pension

scheme had a ‘relevant decit’. In normal circumstances, the relevant decit

was taken to be the greater of the IAS19/FRS17 decit or the PPF buyout

basis decit. This was a pragmatic approach, as schemes had generally not

yet carried out their rst scheme specic funding valuation, and there was no

other consistent measure that would have been suitable. Where a scheme had

completed its rst scheme specic funding valuation, the decit on that meas-

ure would be the relevant decit if greater. This meant that companies which

agreed prudent assumptions with their trustees for funding purposes could be

prejudiced if they later sought clearance. Also, in the event that there was any

concern that the employer was not viable as a going concern, then the buyout

decit would be the relevant decit.

In the period following the issue of the 2005 guidance, the illustrations in

the guidance came to be regarded by many as a comprehensive checklist of the

circumstances in which the moral hazard powers could apply. Further, where

it was commercially viable, some took the approach of ensuring their scheme

did not have a relevant decit by paying additional contributions into a scheme

before embarking on a particular transaction which would have been a Type A

event had there been a relevant decit.

49 For more on valuation methods and approaches, see section 2.2 above.

249

The Pensions Regulator and ‘moral hazard’

Revised guidance has subsequently been issued which is much less pre-

scriptive about what is a Type A event, and how the relevant decit should be

calculated. Under the new guidance, the rst question is whether or not there

is a ‘detrimental event’. This is essentially an event which:

(a) prevents recovery of all or part of a section 75 debt;

(b) prevents a section 75 debt from becoming due;

(d) weakens the strength of the employer covenant.

It should be reasonably clear whether any of the rst three will be taking place.

In general terms (although the position is not always clear), the employer cov-

enant will be weakened if there will be an adverse impact on the employ-

er’s ability or willingness to meet its obligations to fund the scheme on an

ongoing basis, or there is a reduction in the amount that would be available to

the scheme on insolvency.

If there is a weakening of the strength of the employer covenant, there

will only be a Type A event if it is material, i.e. materially detrimental to

the ability of the scheme to meet its liabilities. Relevant factors which go

towards determining if a weakening of the employer covenant is material

are:

(a) the amount by which the covenant is weakened (where this can be

quantied);

(b) the size of the employer after the event;

(d) the amount of the relevant decit.

This can be slightly circular, because the appropriate measure for the relevant

decit depends on the degree of the detriment. Usually, the appropriate meas-

ure for the relevant decit will be the highest of the decits calculated on either

(a) the FRS17/IAS19 basis, (b) the PPF buyout basis, or (c) the scheme specic

funding basis. However, a higher basis may also be relevant where the event

is signicantly material or, as before, if there is concern that the employer

may not continue as a going concern. In the latter case, it seems likely that

buyout will be the appropriate measure for the relevant decit. Similarly, it is

possible that in cases of extreme detriment, which might include highly lever-

aged purchases by private equity buyers, an appropriate measure might be self-

sufciency. This is similar to buyout, but effectively excludes the insurance

company prot from the calculations. It assumes the investments are all in

low-risk, xed-return products, so that the scheme can be continued inden-

itely with no requirement for further funding from the employer. Trustees and

employers will often not agree how the relevant decit should be measured,

and even where they do there is a wide range that can be calculated under each

method. Particularly where the detriment is material (or the trustees perceive

250

Pensions

it to be so), agreeing what the relevant decit is can take some time. In short, it

can be very difcult to ascertain what the correct measure is for the purposes

of determining whether there is material detriment. As the guidance is quite

new, there is relatively little precedent to assist with this question.

Clearance is a voluntary procedure under which the Pensions Regulator

conrms to the applicant that it will not issue a contribution notice or, some-

times, a nancial support direction

in respect of a particular act or omis-

sion (or series of acts or omissions). Clearance is given on the basis of the

information provided to the Pensions Regulator with the application. Detailed

information must be provided. The timetable for any proposal or transaction

therefore needs to include sufcient time to put this information together for

both the trustees (who must generally be involved in any clearance application)

and the Pensions Regulator. Usually, the trustees are asked to enter into con-

dentiality agreements before being provided with condential details about

a transaction and its nancing. A buyer will usually obtain consent from the

seller before engaging directly with the trustees of a seller’s scheme, although

this is by no means always the case. If there is a material inaccuracy or omis-

sion in the information provided to the Pensions Regulator, the clearance will

be worthless.

Ideally, the trustees should negotiate the terms of any clearance and

support the application. The Pensions Regulator suggests that the trustees

should behave like bankers, and normally expects the trustees to take inde-

pendent nancial advice. The Regulator regularly emphasises that it wants

to be a referee, and not a player, in clearance negotiations. In practice, how-

ever, the Regulator often adopts a much more active role than this suggests.

Occasionally, clearance is granted where the trustees (perhaps unreasonably)

refuse to support the application. More often, the Regulator will require

more mitigation in exchange for granting clearance than the trustees have

negotiated.

3.5 Associates and connected persons

The test to determine whether a particular person or entity is connected with or

an associate of a scheme employer can be quite complicated, and may have far-

reaching consequences for private equity transactions. For example, it includes

not only a holding company, but extends to cover any shareholder with one-

third or more of the voting power at a general meeting of the scheme employer.

It could also catch an investor with a smaller equity stake, if the board of dir-

ectors of the scheme employer is accustomed to acting on the direction of that

person. Further, having a common director makes companies connected for

these purposes.

50 As noted in section 3.3, generally this will not be possible since nancial support directions

are not fault-based but depend on the resources of employers and their associates at any point

251

The Pensions Regulator and ‘moral hazard’

The terms ‘associated’ and ‘connected’ have the meanings given to them

in the Insolvency Act 1986. In simple terms, a person is ‘connected’ with a

company:

(a) where the person is a company, it is a director or shadow director of the

company or an associate of such a director or shadow director;

(b) where the person is a limited liability partnership (LLP), it is a member or

shadow member of the LLP or an associate of such a member or shadow

member; or

The denition of ‘associate’ in the Insolvency Act 1986 is extensive,

and

covers a range of situations between individuals and companies. A person is

an ‘associate’ of an individual if that person is:

(a) the individual’s husband or wife or civil partner,

(b) a relative of:

(i) the individual; or

(ii) the individual’s husband or wife or civil partner; or

(i) the individual; or

(ii) the individual’s husband or wife or civil partner.

A person is an associate of any person with whom he is in partnership, and of

the husband or wife or civil partner or a relative of any individual with whom

he is in partnership; and a Scottish rm is an associate of any person who is

a member of the rm. A person is also an associate of any person whom he

employs or by whom he is employed.

A company is an associate of another company:

(a) if the same person has control of both, or a person has control of one and

persons who are his associates, or he and persons who are his associates,

have control of the other, or

(b) if a group of two or more persons has control of each company, and the

groups either consist of the same persons or could be regarded as consist-

ing of the same persons by treating (in one or more cases) a member of

either group as replaced by a person of whom he is an associate.

Finally, a company is an associate of another person if that person has control

of it or if that person and persons who are his associates together have control

of it.

in time. There was a ‘squash court clearance’ process, which allowed for a clearance in re-

spect of nancial support directions, provided that certain conditions were met before any

dividend was paid, but this proved difcult in practice and was not widely used.

51 Section 249 of the Insolvency Act 1986.

52 Section 435 of the Insolvency Act 1986.

252

Pensions

For these purposes, a person has control of a company if:

(a) the directors of the company (or another company which has control of it,

or any of them) are accustomed to act in accordance with his directions or

instructions; or

(b) he is entitled to exercise, or control the exercise of, one-third or more of the

voting power at any general meeting of the company (or of another com-

pany which has control of it).

Therefore, a private equity rm may be connected with a scheme employer,

depending on the particular structure of the rm’s funds and the investment by

those funds. For example, even where steps have been taken to ensure that the

shareholding of an investor is less than 50 per cent of the share capital of an inves-

tee company (as often occurs to avoid the investee company being a subsidiary

of such investor), such investor may nevertheless be an associate of or connected

with it. Similarly, where funds have been established using a limited partnership

structure as typically encountered in the UK, the general partner may well be

associated or connected with the employer depending on the shareholding of each

fund, the overall fund structure, and the relationships between different funds.

4 Private equity transactions

4.1 Introduction

We have already made reference to a number of situations where the issues

concerning the triggering of a section 75 debt, or the moral hazard legislation,

can have implications for private equity rms. With the substantial body of

legislation now surrounding pension schemes, and the uncertainty created by

some of the broader provisions, it can be difcult for practitioners to identify

exactly which issues will apply to any particular situation in practice. In this

section, we will briey outline the key issues typically encountered in the pri-

vate equity arena. It is beyond the scope of this book to provide comprehensive

details on all of the issues that might be faced; however, it is intended that this

section, combined with the background information that preceded it, will pro-

vide the reader with a useful starting-point for tackling this complex area.

The pensions issues that arise on the initial acquisition will vary depending

on whether the acquisition is to be structured as a share purchase or an asset

purchase. Where the acquisition will involve a purchase of shares in Target (as

is more usual, although the existence of a scheme may in itself be a factor in

deciding that the deal should be structured by way of asset purchase instead),

it is essential to establish whether Target is the principal employer of a pension

scheme, in which case the pension scheme will be acquired along with the

Target unless steps are taken to change the principal employer to a group com-

pany retained by the seller, or alternatively whether Target is a participating

employer in the seller’s group pension scheme.

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Private equity transactions

We will begin by explaining the issues in the case where Target is a par-

ticipating employer, and the initial transaction is a share acquisition, as this

is most frequently encountered. We will then look at the issues faced where

Target is the principal employer, and then the issues on an asset rather than a

share purchase, before concluding with a summary of the issues faced if Target

continues to offer nal salary benets during the lifetime of the investment

and on exit.

4.2 Issues when acquiring a Target which is a participating employer

If Target participates in a seller group pension scheme, the most likely impact

of the transaction is that Target will cease to participate in the scheme from

completion, in which case a section 75 debt will become payable by Target.

The issues for the buyer are:

What is the estimated section 75 debt that will be triggered?•

Will steps be taken to seek to obtain the agreement of the trustees (and, •

where appropriate, the Pensions Regulator) to reduce the section 75

debt?

Who will actually pay the section 75 debt and, if it is not the Target, how •

will the Target receive an effective discharge of its liability?

Are there any other provisions which may impose liability on Target, in •

particular under the scheme rules?

Are there any moral hazard issues?•

What future service benets will be provided and how?•

Will the buyer accept liability for past service by allowing for past ser-•

vice transfers?

(a) The section 75 debt

Unless action is taken to change the position, a section 75 debt will be pay-

able by Target when it ceases to participate in the scheme on its acquisition by

the private-equity-backed Newco. There are various options for dealing with

this including reaching agreement with the trustees that the amount due will

be a reduced amount (possibly nil), and/or that the debt will be payable by a

different party, using the statutory provisions described in section 2.3 above.

Another key issue will be whether any payment made to the scheme is eligible

for tax relief.

Where a section 75 debt will be triggered, the most common outcomes are

as set out below.

(i) Target pays the section 75 debt in full A complexity with this approach is

the fact that the actual amount of the section 75 debt will not be known for

some time after completion, when the section 75 debt has been certied by

the scheme actuary and demanded by the trustees. It is therefore difcult to

estimate with any accuracy the appropriate price reduction before completion.

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Pensions

Where this approach is adopted, the price adjustment is usually made after

completion, when the actual amount of the debt is known.

An amount equal to an estimate of the section 75 debt is sometimes held

in a retention account.

When the section 75 debt is calculated, the amount

needed to pay the section 75 debt can then be released to the Target (or to the

buyer, who must procure that the Target pays the section 75 debt), with any

balance remaining being released to the seller, or any shortfall being made

good by the seller, as applicable. It must be Target and not the buyer that pays

the section 75 debt in order for tax relief to be available. An adjustment is then

made to the purchase price to reect the payment by Target.

(ii) Seller pays or procures payment of the section 75 debt in full This can be

more straightforward, as there is no need to reduce the purchase price. The

seller will seek to ensure that tax relief is available, whilst the buyer will want

to ensure that the liability of Target is discharged, as quickly as possible. The

seller could make the payment as the Target’s agent, although this needs to be

documented carefully.

A withdrawal arrangement

can be used to transfer the liability from Target

to the seller group company that will make the payment. The trustees should

not have difculty in agreeing such a withdrawal arrangement that involves

payment of the section 75 debt in full.

(iii) Target pays the section 75 debt in part A withdrawal arrangement can be

entered into whereby a reduced section 75 debt is paid by Target, with the bal-

ance being guaranteed by an appropriate seller group company. This requires

the agreement of the trustees, the Target and the guarantor. Unless the arrange-

ment is approved by the Regulator, the reduced debt payable by Target must be

at least equal to Target’s ‘share’ of the decit calculated on the scheme-specic

funding basis. The actual debt that will be paid by Target will need to be fac-

tored into the purchase price (in advance if possible, or as a price adjustment if

not). The time needed to secure the trustees’ agreement must be factored into

the transaction timetable.

The trustees must be satised that the guarantors

would be able to pay the

estimated guaranteed amount, and the ‘funding test’ is met, before they have

the power to agree.

An alternative would be to enter into a scheme apportionment arrange-

ment whereby a reduced section 75 debt (potentially nil) is paid by Target

with the balance being apportioned to one or more other participating (seller

group) employers. The trustees, Target and the employers taking an additional

liability all must agree. This can be attractive to companies, as a separate for-

mal guarantee is not required, but will only work if there is an appropriate

53 See chapter 4, section 2.4, concerning retention accounts generally.

54 See section 2.3 above.

55 See section 2.3 above.

255

Private equity transactions

company that is participating. In appropriate circumstances, a company can

become a participating employer to facilitate this approach.

A material factor for the trustees in deciding whether to agree to a scheme

apportionment arrangement will be the proposed use by the seller of the sale

proceeds from the transaction. If they are to be retained within the seller group

which sponsors the pension scheme, they may be more likely to agree. If there

is to be a dividend to a parent company which has no formal obligation to fund

the scheme, or to ultimate shareholders, the trustees may be less likely to do

so, or may in that situation insist that a proportion of the section 75 debt is paid

by Target.

As any such arrangement reduces the amount of a section 75 debt that will

be payable by the exiting company, the parties should also consider whether

it is a Type A event and whether clearance should be sought. A private equity

buyer will be particularly concerned about any risk of liability being imposed

on Target which has not been reected in the purchase price. If the seller is

sufciently strong, that risk may be able to be addressed with an indemnity

alone. However, it is more prudent (and therefore more likely) that clearance to

the proposal will be sought from the Regulator, or alternatively that a regulated

withdrawal arrangement will be used (see further section (c) below).

(iv) Target continues to participate in the seller group scheme after

completion This approach avoids triggering a section 75 debt at the time

of completion. However, it is often unattractive for a number of reasons,

including:

The section 75 debt is merely delayed until Target in fact ceases to employ •

scheme members. Protection against this liability, which will not arise until

an unknown time in the future, is difcult to achieve. An indemnity might

be sought for such liability, but that of course relies on the continued strength

of the person providing the indemnity.

Target will be required to continue to pay contributions to the scheme, •

but will most likely have no input into how those contributions are set.

Contribution caps and indemnities can be negotiated, but, as there is a direct

liability from Target to the scheme, these will again only be effective if the

seller group remains of sufcient nancial strength.

The whole buyer group will be connected to Target, which remains a scheme •

employer for the purposes of the moral hazard legislation, and as a result

will be exposed to the Regulator’s moral hazard powers.

It is therefore unusual for this solution to be adopted, although it should not be

overlooked altogether. For example, it may be appropriate if the seller group is

strong and the number of affected employees is small.

(b) Other provisions imposing liability

A crucial part of the due diligence process will be the review of the scheme’s

governing documents, to assess whether there are any provisions under which

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Pensions

liability can be imposed on Target. For example, scheme rules may include

provisions requiring contributions on exit which are similar to section 75

debts. They are relatively unusual, but must be dealt with at the same time as

the section 75 debt when they exist.

Another key issue on the acquisition of a Target which is a participating

employer is the question of whether there are any moral hazard risks associ-

ated with the transaction. If the section 75 debt is paid in full, then it seems

unlikely that there should be any moral hazard risks for the Target in respect

of the seller’s scheme. Nevertheless, it is not unusual (and generally consid-

ered reasonable) for the buyer to request indemnity protection from the seller.

A contribution notice could technically be imposed for up to six years if the

Target was involved in a relevant act or omission prior to completion. A nan-

cial support direction could be imposed for up to two years after completion

if any scheme employer is ‘insufciently resourced’ during that time (or is a

service company).

The Pensions Regulator can only impose liability on a person if it forms

the opinion that it is reasonable to do so. It is difcult to see how this conclu-

sion could be reached if Target paid its section 75 debt in full. Nevertheless,

it is usual to nd indemnity protection, or at the very least robust warranty

cover, even when a section 75 debt is to be paid in full. If the seller group is not

strong, this risk should be considered further; if the seller group were to fail,

the Regulator may regard a strong Target backed by private equity funders as

an attractive party to pursue.

If a section 75 debt is not to be paid in full, the buyer will need to con-

sider very carefully the associated moral hazard risks and how they are to be

addressed. As noted above, a withdrawal arrangement or scheme apportion-

ment arrangement which reduces a section 75 debt is potentially a Type A

event. The simplest option would again be an indemnity from the seller, which

is usually not resisted (since it would be unreasonable to expect Target or the

buyer to make a payment into the seller’s scheme which has not been factored

into the purchase price). If the buyer is not comfortable relying on the seller’s

indemnity, particularly for a larger exposure where the seller’s group ongoing

covenant is more questionable, then an alternative solution will be required.

One option would be a regulated withdrawal arrangement. Although this

is different from clearance, it is difcult to see how the Regulator could form

the view that it is reasonable to impose liability on Target in circumstances

where the Regulator approved the agreement whereby the section 75 debt pay-

able by Target was reduced. This could lead to parties seeking approved with-

drawal arrangements even where a scheme apportionment arrangement or an

(unapproved) withdrawal arrangement would have been possible.

The other alternative is to seek clearance. This has typically been the

approach adopted, although it can be an expensive option as the Regulator