Bagging a bargain? Purchasing businesses with DB pension schemes

There are many accepted truths about buying a company, such as the well-worn adage that a deal will always take longer, and be more complex than anyone, even the corporate lawyers, predicted.  Amongst the “facts” that many acquirers will follow is that you should never, ever buy a company with a defined benefit pension scheme.

The thinking behind this is perfectly rational. Defined benefit pension schemes are heavily regulated and, as the last 12 months or so have clearly illustrated, have a tendency to create anti-employer headlines if things don’t go according to plan. In addition, the funding required is uncertain, and the experience of the last two decades is that costs have continually risen, whilst ever growing regulation makes it increasingly challenging to manage the costs.

As a result, there was a distinct move in the 1990s and beyond for purchasers to refuse to buy the pensions scheme, and demand that the seller got rid of it as part of the process to make a business sale ready. More urgent sales involved the purchase price being adjusted to take account of the cost of getting rid of the pension scheme post-sale, often significantly reducing the purchase price.

This route became less practical as the cost of closing down pension schemes increased. As a matter of law, closing down a pension scheme requires the employing company to pay the cost of securing all the rights under the pension scheme with an insurance company. The cost of this has continually risen for the last twenty years, and it is now quite rare that the cost is less than the value of the business.

The end result is that a lot of acquirers have taken on the rule that they should not buy a business with a defined benefit pension scheme. Many turn up their nose the moment a defined benefit pension arrangement surfaces.

But, is this really the right way to go? Businesses are full of uncertainties that cannot be quantified – something as simple as weather can radically change the cost of raw materials, unexpected election results (and one might argue that there aren’t any other kind any more) can dramatically affect exchange rates, and litigation claims might arise from the most unlikely sources. No one buys a business knowing the costs and returns, but just with an indication of what they are likely to be.

Pension scheme liabilities, like any other, can be understood, even if not fully predicted. A pension scheme is no more a black hole than any other business liability. It does depend on unknown factors, such as investment returns, life expectancy and wage growth, but many of these, particularly the financial factors, are those that directors already need to consider in their other business activities.  For those that are more unusual (such as the demographic factors), there are expert actuaries to advise.

There are often other challenges – historically many pension schemes have not been properly managed and liabilities have been understated as a result of underinvestment in administration, and a lack of legal advice. However, proper due diligence can flush out the issues and actuarial experts can help assess how much any issue affects the liability cost.

A proper due diligence procedure can present the purchaser with an indication of the costs and a range of likely growth or otherwise in liabilities. A purchaser with sound advice can assess the pension cost and risk, and so adjust their proposed price for the business, just as they can with other issues thrown out by the due diligence process.

Still, however, a large number of purchasers run shy.  Even those who are happy to buy a company with a product liability claim, a dependency on a politically unstable region for raw materials or a history of labour disputes, often shudder at the idea of a pension liability.

Pensions retain a mystique of complexity in the minds of many business people. They are seen as unknowable rather than a business liability. Certainly, the law around them is a mixture of 12th century constructs of trust law and modern Parliamentary interference, but the underlying concept is a simple business proposition: employers agree to provide a benefit for employees under a formula based on years of service and salary, employees and employers pay in money which is invested, and any shortfall between the funds and the promised pension is met by the employer.  The uncertainties lie between the investment returns on the fund, the costs of providing a pension (linked mostly to life expectancy and the availability to insurers of gilts to hold as investments) and changes to the pension calculation if wages rise.

A pension scheme is, in most ways, just another financial proposition and one that most finance directors can come to grips with without significant difficulty. Those that do, and that have the right advice, are able to contemplate a defined benefit pension scheme as just another uncertainty of the business.

Increasingly, some purchasers are seeing this as the way forward. With experience and good advice, they are able to assess the liabilities and risks appropriately and make the necessary adjustments to an offer.

It seems that these purchasers may be spotting an arbitrage opportunity. The instinctive fear of defined benefit pension schemes by some many acquirers means that there are almost always significantly fewer bidders for a business with a defined benefit pension scheme in its mix. As any finance director knows, if the level of demand falls, so does the price. An acquirer who is able to assess the pension risk and build it into their price will see fewer (and sometimes no) competing bids for the business, and prices will necessarily fall.

Businesses that are unable to contemplate a defined benefit pension scheme may find that they are missing a trick. Their competitors are able to purchase a business at a reduced price because, with some understanding of the environment and appropriate due diligence, they have taken on the pension risk, at an appropriate price, alongside all the other risks in the business.

Rosalind Connor is a partner at ARC Pensions Law LLP.

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