A Practical Guide to Private Equity Transactions
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Private equity transactions
has, until recently, usually required the decit (calculated on a scheme-specic
funding basis, accounting basis or PPF buyout basis, whichever creates the
greatest decit) to be fully funded, usually over a short period of say three to
ve years, in exchange for granting clearance. Recently, in part in response to
the more challenging economic times, the Regulator has in appropriate circum-
stances indicated a willingness to be more exible, for example by accepting
non-cash mitigation rather than insisting on the full decit being paid in cash.
Such mitigation might include guarantees or liability-reduction exercises,
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which combined with a smaller cash contribution can eliminate the decit.
If any guarantee were given as part of such a package, it should ideally not
exceed the expected period of ownership. Guarantees also add extra complex-
ity on exit; they may need either to continue or to be replaced. In any event,
private equity funds are unlikely to be willing or able to provide such guaran-
tees themselves.
The seller may have its own moral hazard concerns. This will be the case
if there are any proposed Type A events associated with the sale, such as the
payment of a dividend, or if the sale of one subsidiary could impact on the
strength of covenant of the remaining group (for example, if the companies
supply goods to one another, have common customers, or have inter-company
debt to be taken into account).
If the seller or the buyer wants to make the obtaining of clearance a condi-
tion precedent to the transaction, this can cause delays and, possibly, prevent
the transaction from completing.
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It is therefore important to identify at the
outset whether this is an issue and involve the trustees and the Regulator so
that they are ready to respond quickly where necessary.
(d) What future service benefits will be provided?
Assuming the Target ceases to participate in the seller group scheme, alterna-
tive arrangements will need to be made for future service pension benets for
affected employees.
Considerations are:
(a) Do employees have a contractual right to any particular type of benets?
Often, employees (senior executives in particular) may have express con-
tractual provisions entitling them to be a member of a dened benet
scheme, possibly with a pre-determined level of benets. Usually, care is
taken to ensure that the right to be a member of a pension scheme is sub-
ject to the scheme’s trust deed, and rules which confer powers to amend or
terminate the scheme. Employees from privatised industries or who were
outsourced from the public sector often have such statutory or contractual
rights.
56 Liability-reduction exercises are steps to reduce scheme liabilities through transfer or buy-
outs. See further section 4.5 below.
57 On conditions precedent generally, see chapter 4, section 2.5.
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Pensions
(b) Will there be an adverse reaction from employees if less generous future
service benets are provided? In difcult economic times, this may be
less likely, as employees will be protective of their jobs, but in prosperous
times this can be a signicant concern.
(c) In 2012, legislation is expected to be introduced requiring employers to
provide a minimum level of pension benets (e.g. for a dened contribu-
tion scheme, minimum employer contributions of 3 per cent).
If there is a contractual right to particular benets, the buyer will need to con-
sider what steps to take to mitigate the risks of employees disputing a unilateral
change to their contracts of employment, for example by obtaining individual
consents to the new terms. If there is no right to particular benets, Target can
provide whatever pension benets it likes, subject to compliance by Target
with its duty of mutual trust and condence to its employees and, if they are
introduced from 2012, the new minimum requirements.
In this regard, it is helpful if a meaningful consultation is undertaken with
employees. There is an obligation under the Pensions Act 2004
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to consult
with employees for a minimum period of sixty days over changes to future
service pension benets. Historically, there was no clear sanction for breach
and, in particular, a breach does not invalidate the change itself – although,
from April 2009, changes to this legislation mean that a breach could lead to a
£50,000 ne. It is also not clear from the legislation whether the obligation to
consult applies in the context of changes made as a result of corporate trans-
actions, rather than in the ordinary course of business without any change of
ownership. In practice, a shorter consultation is often carried out in the case
of transactions because of time constraints, or consultation is carried out post-
completion with the changes then being backdated.
Of course, a private equity buyer may consider that the acquisition is an
opportunity to reduce staff benet costs. However, the removal of a pension
benet may often constitute a signicant reduction to the remuneration pack-
age of employees. To avoid unnecessary adverse impact on morale, or claims
that the change is a breach of contract or the employer’s duty of trust and con-
dence, it is prudent to approach any proposed change sensitively, consulting
where possible.
(e) Past service transfers
Sellers may try to impose an obligation on buyers to accept liability for past ser-
vice benets, by a contractual commitment to allow transfers in respect of past
service benets to the buyer’s new scheme. This would reduce the liabilities in
the seller’s scheme and, depending on how the amount of the transfer payment
is calculated, may improve the funding position. This is often particularly
attractive to sellers with large schemes, or where the Target employees represent
58 Sections 259–261 of the Pensions Act 2004.
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Private equity transactions
a signicant proportion of the active members of the scheme. Transferring past
service liabilities may reduce the section 75 debt, and may assist in obtaining
agreement from the trustees to a withdrawal arrangement (as a transfer would
result in the same business continuing to back the same pension liabilities).
Transfers c an be made without employee consent if the past service ben-
ets offered by the buyer’s scheme are broadly no less favourable than the ben-
ets in the seller’s scheme (which in practice usually means identical or close
to it). If the benets are to be different (most obviously, if the buyer’s scheme
is dened contribution), then individual employees’ consents will be required.
A transfer without consent will therefore only be appropriate if the buyer will
provide a dened benet scheme for Target employees. Private equity buyers
generally resist such a proposal – having a dened benet scheme will prove
burdensome during the life of the investment, and cause the same issues on
exit as those encountered by that buyer on purchase.
It may be attractive to allow employees to take past service transfers to a
new dened contribution scheme on an enhanced basis. This allows the seller
to rid its scheme of liabilities, and may well improve the funding position of
the seller’s scheme on both an accounting basis and a scheme specic fund-
ing basis (and almost inevitably will do so on a buyout basis) notwithstanding
the enhancement. Although buyers may not be agreeable to accepting such
transfers in all cases, it can help ensure that a transfer to a dened contribution
scheme is received more positively by employees. Of course, the clean break
offered to the seller by such a proposal can be reected in price negotiations
between the parties.
4.3 Target has its own pension scheme
Where Target is the principal employer, the pension scheme will effectively
transfer to the buyer group, and therefore the position of the scheme will be
even more central to the underlying transaction.
The areas that must be considered and negotiated are complex, necessitat-
ing detailed discussions and negotiations between all parties, with the benet
of actuarial advice where appropriate. The main issues to be considered are
the following.
(a) Agreeing the implications for the price
Most fundamentally, an appropriate adjustment will be needed to the purchase
price to reect the scheme funding level. This will require actuarial a dvice,
and is invariably an area of intense negotiation.
(b) Funding obligations of Target going forward
The trustees may seek to accelerate Target’s contribution obligation if they have
concerns over the viability or the ongoing ability and willingness of Target
to fund the scheme following the transfer of ownership. In the context of a
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Pensions
leveraged private equity deal, the trustees may very well take a more prudent
approach towards funding after completion, as they will be concerned that there
may be an impact on both ability to pay (because servicing acquisition debt will
reduce available cash) and a willingness to pay (because of a perception that
private equity owners will be more reticent about funding).
This would be consistent with Regulator guidance, which places signi-
cant emphasis on the importance of the strength of the employer covenant as a
cornerstone for funding matters.
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The buyer will have to undertake signicant
discussions and negotiations with the trustees in this respect.
(c) Additional due diligence
The focus of legal due diligence in recent years has often been around moral
hazard risks and the extent of the section 75 debt where Target is a partici-
pating employer. Where Target is the principal employer, it is essential that
due diligence also identies any powers the trustees have which may be of
ongoing concern. For example, they will typically have power to trigger a valu-
ation (with the practical result that the trustees then use such valuation exercise
to seek an increase to contributions), and power to switch to a more prudent
investment strategy (which will ultimately increase costs). They may have uni-
lateral power to x employer contribution rates, or to trigger a winding up of
the scheme (which would trigger a section 75 debt).
Further unfunded liabilities may also be identied by due diligence, for
example if a scheme closure or reduction in benets has not been validly
adopted (as often arises if a scheme has attempted to reduce future service
accrual or close without the drafting being closely scrutinised from this per-
spective) or if a scheme has benets which are discriminatory (as between men
and women, or on the grounds or age).
(d) Moral hazard
It will be necessary to consider whether clearance from the Pensions Regulator
should be sought, and if so what the funding and timing implications are likely
to be. This is particularly important for a private equity buyer as part of a
highly leveraged transaction, as this will inevitably be regarded by the trustees
and Pensions Regulator as detrimental as the scheme will transfer to a highly
leveraged group where the ability and willingness of the employer to fund the
scheme are very likely to be regarded as having been adversely affected.
4.4 Target is acquired as an asset purchase
Where the acquisition is structured by way of an asset purchase, there are no
moral hazard risks for the buyer in connection with a seller group scheme (unless
59 See Regulator Codes of Practice on ‘Funding dened benets’ and ‘How the Pensions
Regulator will regulate the funding of dened benets’.
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Private equity transactions
a buyer group company is connected with a seller group scheme employer, e.g.
if there are common directors). The seller may have moral hazard concerns,
for example if it proposes to distribute the sale proceeds. Similarly, if a seller
group company will cease to participate in a seller group scheme as a result
of the sale, a section 75 debt may be triggered. This will be a concern for the
seller and not the buyer; a buyer of a business where the Target employees par-
ticipate in a dened benet scheme will only be concerned about these issues
to the extent that they raise commercial issues (particularly as to timing) for
the seller to the point that this has an impact on the transaction as a whole.
The buyer’s other concern will relate to what future service benets should
be provided. The decision as to the future service benets can be difcult for
the would-be buyer in a competitive bid situation. Providing ungenerous ben-
ets may be a disadvantage if the seller is paternalistic towards its employees,
is concerned about the perception of retained employees, or if there is strong
union involvement. Conversely, assuming more generous provision may result
in the bid price seeming uncompetitive, if another bidder makes less provision
for future service costs.
The obligations on the buyer of the business will be governed by
the Pensions Act 2004 and the Transfer of Undertakings (Protection of
Employment) Regulations 2004 (TUPE). Under the Pensions Act 2004, and
regulations made thereunder,
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the buyer must provide a minimum level of
pension benets for future service. The minimum benets to be provided de-
pend on whether the buyer’s scheme is dened benet or dened contribution.
In summary, the minimum is:
(a) dened contribution scheme: employer contributions of up to 6 per cent to
match the rate of contributions paid by the employee. This is limited to 6
per cent of ‘basic pay’. Note that this applies even if the seller’s scheme was
less generous than this; or
(b) dened benet scheme: a scheme which meets a qualitative test (broadly,
a nal salary scheme which provides one-eightieth of average qualify-
ing earnings for each year of pensionable service), or which meets fairly
ambiguous prescribed criteria (which broadly suggests the minimum
employer contribution towards the benets should be at least 6 per cent of
pensionable pay).
It is possible for the employee and the buyer to agree to contract out of these
obligations after completion.
If the transferring employees were formerly members of a dened benet
pension scheme, they may also have rights to redundancy or early retirement
benets which transfer under TUPE. Under TUPE, the rights and obligations
relating to employees are generally transferred from the seller to the buyer
60 Sections 257 and 258 of the Pensions Act 2004, and the Transfer of Employment (Pension
Protection) Regulations 2005.
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Pensions
on an asset sale. This means that an employment contract has effect after a
transfer as if it had been originally made between the employee and the buyer.
However, there is an exception for rights to old age, invalidity and survivors’
benets under an occupational pension scheme.
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This means that an employ-
ee’s rights to these benets under an occupational pension scheme, whether
the seller’s scheme is dened benet or dened contribution, will not transfer
to the buyer.
However, whilst rights to old age, invalidity and survivor benets under
an occupational scheme do not transfer, any other benets under an occupa-
tional pension scheme will transfer under TUPE. Obligations under an em-
ployment contract to make contributions to personal pension schemes transfer,
as do obligations to provide life assurance benets through schemes which are
not occupational pension schemes. Two decisions of the European Court of
Justice
62
are authority for redundancy benets under pension schemes trans-
ferring under TUPE, along with other benets payable before the scheme’s
normal retirement age, e.g. a right to retire early.
There are arguments that this principle will not apply in the private sec-
tor, since both of the cases referred to above involved public sector schemes
where the redundancy/early retirement pension was a separate benet from
the pension at normal retirement age (i.e. the schemes did not simply put the
old age pension into payment, and so this was arguably a separate contractual
entitlement). However, these technical arguments have never been tested, and
it is therefore common practice to address these potential liabilities in the asset
purchase agreement. Such rights are often referred to as ‘Beckmann rights’,
named after the rst of the aforementioned European cases.
Unlike the minimum obligations under the 2004 Act, the employee and
the buyer cannot contract out of these rights. It is therefore a key piece of due
diligence to identify what Beckmann rights there are in a seller’s scheme, and
consider how to address them. Options for addressing such rights are:
(a) ignore them for the purposes of future pension provision (and seek to man-
age the risk of claims being brought);
(b) seek indemnity protection for past service benets, and possibly also for
future service costs (particularly where redundancies are envisaged in the
short term);
(c) replicate the benets for the future (in practice, this is relatively unusual,
particularly for private equity buyers who will not usually have a scheme
in place with which to replicate the benets, and will not want to establish
one);
(d) replicate the benets for a period, and seek to change them at a later date
in a way that is not associated with the TUPE transfer (again, this would
61 TUPE, Regulation 10.
62 Beckmann v. Dynamco Whicheloe Macfarlane Ltd [2000] PLR 269; and Martin v. South
Bank University [2004] IRLR 74.
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Private equity transactions
be unusual for a private equity buyer which did not already have a scheme
in place);
(e) participate in the seller’s scheme (this is very unusual because of the
moral hazard risks and section 75 debt issues arising where a non-group
company continues to participate in a scheme, as outlined in section 4.2
above).
The degree of risk as to whether Beckmann benets may become payable will
inuence the approach taken to address the risk, and possibly the decision as
to what future service benets will be provided.
As for a share purchase where Target is only a participating employer, there
is no obligation for a buyer to involve itself in past service benets. However,
offering to accept transfer payments in respect of past service benets (see
section 4.2 above) may again be helpful – and may result in a lower price being
acceptable, as the seller will reduce its liability under its retained dened bene-
t scheme.
4.5 Issues during ownership and on exit
There will usually only be material pension issues for a private equity buyer
during ownership, or on ultimate exit, if the Target is a principal employer, such
that the buyer effectively acquires a dened benet pension scheme. There are
references above to situations where a buyer might establish a dened benet
pension scheme, but in practice this is extremely unusual.
Where a private equity buyer does nd itself owning a company or group
with a dened benet pension scheme, for whatever reason, it will be import-
ant during the period of ownership:
(a) to ensure that the employer company does not pay contributions to
the scheme which will not ultimately be reected in the sale price on
exit;
(b) to prevent the trustees (to the extent it is possible) from adopting more pru-
dent assumptions, which could lead to a reduction in the sale price at the
time of exit because of a deteriorated funding position; and
(c) to maintain a good working relationship with the trustees to ease any
discussions that may be necessary in relation to any Type A events that
may occur during ownership (e.g. payment of dividends), section 75
debts that may be triggered during ownership (if Target is a group of
companies and there is a restructuring during ownership), or at the time
of exit.
If any Type A events occur during ownership, consideration should be given to
seeking clearance.
It may be preferable to pay amounts into the scheme during ownership
(which should ultimately be reected in the sale price), rather than waiting to
pay amounts into the scheme after exit (which will not be reected in the sale
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Pensions
price). The Focus DIY case referred to above
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highlights the possibility of a
private equity rm being required to contribute to a scheme after exit if issues
are not addressed during ownership.
With a view to maximising return on exit, and reducing the negative impact
that a dened benet scheme may have on how attractive Target may seem to
potential buyers, an owner may wish to consider whether any liability manage-
ment exercises should be pursued. These could involve:
(a) reducing future service benets (to reduce the extent to which liabilities
increase during ownership);
(b) closing the scheme to future accrual, to prevent further dened benet
liabilities from accruing;
(c) offering deferred pensioner members (enhanced) cash transfer values to
reduce scheme liabilities;
(d) encouraging the trustees to buy out portions of the scheme liabilities with
an insurance company if and when the market conditions are attractive;
(e) encouraging the trustees to follow a different investment strategy, if it is
felt either that the trustees should:
(i) invest more prudently to reduce volatility – an owner may wish to
reduce the risk of scheme asset values dropping, which would increase
the decit and increase a price adjustment on exit (while accepting that
the long-term expected returns will be lower); or
(ii) invest less prudently to maximise return – an owner may prefer to see
the trustees invest in assets with greater anticipated returns which,
over the long term, could reduce costs.
These techniques should help to reduce any price reduction that is made in
respect of the pension scheme at the time of exit.
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If Target has its own dened benet pension scheme, then clearly the issues
raised in the context of the original acquisition in the preceding sections will
again apply on a subsequent sale. Such issues will also arise on a sale by Target
of any subsidiaries, or underlying businesses or assets, by way of partial exit. A
private equity buyer must always be mindful of how the issues on the original
deal will return, in reverse, on exit if Target has a dened benet scheme.
On any exit or partial exit, thought must be given to whether clearance
should be sought in connection with the sale. If clearance is obtained, there
is relative certainty of a clean exit, and that there will be no post-completion
surprises. If the Target is highly leveraged immediately before sale, then it is
perhaps less likely that the sale itself will be a Type A event – the position of
the trustees, as unsecured creditor, may not be worse (or may even be better)
after the sale when compared with before. However, where the acquisition debt
63 See section 3.3 above.
64 As outlined in section 4.2, such techniques can also reduce the cash contribution required to
obtain clearance.
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Conclusion
has been repaid or partially repaid, there may well be a Type A event, particu-
larly if the sale is to a new leveraged buyer rather than a trade acquirer with a
strong balance sheet.
As ever on exit, consideration must be given to the comfort that was
obtained on the original transaction, in order that the comfort offered to the
ultimate buyer on exit matches that protection. For example, where the Target
was acquired by way of asset purchase rather than a share purchase, it will be
important to seek to ensure that any warranties or indemnities for Beckmann
liabilities
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do not go wider than the warranties or indemnities that were given
at the time of purchase.
5 Conclusion
Private equity investors often seek to avoid acquiring or investing in compan-
ies with dened benet pension schemes. This is understandable, as the poten-
tial liabilities are often material and volatile, and the issues which need to be
addressed are complex. However, there are steps that can be taken to reduce
the impact of a dened benet scheme, and private equity investors should not
necessarily dismiss an otherwise attractive investment simply because of the
existence of such a scheme. There are steps that can be taken to mitigate the
risk and, with actuarial advice, the risks can also be factored into the price.
The attention to legislative developments in the press often focuses on
the negative – the increased breadth of the Regulator’s powers, for example.
However, there have been helpful developments too, such as the new arrange-
ments for dealing with section 75 debts, and there are indications that there
may be further developments in this area, for example so that section 75 debts
will not arise on internal restructuring. The more challenging economic con-
ditions experienced in the UK since the credit crunch of 2007 have had an
adverse impact (in terms of the impact of volatility in the markets on funding
decits), but have also equally led to the Regulator taking a more pragmatic
approach to facilitate transactions which ultimately make sense for all of the
relevant parties.
65 See section 4.4 above.
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9
Tax on private equity transactions
1 Introduction
In this chapter, we will consider the tax issues for the private equity investor,
Newco and the managers of the investee company in respect of a UK private
equity transaction, and how such tax issues impact upon the structure of a
private equity transaction including the form of debt nance. The tax issues
of the different parties are dealt with in turn; however, in reality, many of
the issues are overlapping. For example, if Newco is unable to obtain a tax
deduction in respect of the coupon upon the investor debt, this will have an
impact for both the investor and the managers, as it will result in a higher tax
charge within Newco which will impact upon the value of their investment in
Newco.
In chapter 3, there is a detailed analysis of transaction structures, including
diagrams to demonstrate those structures most often encountered. This tax-
ation chapter assumes a transaction structured in such typical fashion. As out-
lined in that chapter, it is increasingly common for a double (or more) Newco
structure to be used, one reason for such a structure being the desire that the
investor’s equity funding should be provided to a different company than that
to which the investor’s debt funding is provided for the tax reasons outlined in
section 3.2 below. Generally, where there is more than a double Newco struc-
ture, this is driven by the non-tax reasons (such as the desire to achieve struc-
tural subordination) discussed in chapter 3. For ease, references to ‘Newco’ in
this chapter are, unless otherwise indicated, a reference to each of the Newcos
in the structure.
2 Tax issues for the investor
2.1 Structure of the investor
It is beyond the scope of this book to consider in detail the different structures
adopted by investors which invest in UK investee companies. However, such
structures and the tax aims associated with them do impact upon how under-
lying investments are made in UK private equity transactions.