Even though pensions have a significant financial impact on M&A deals, they often are addressed too late in the deal lifecycle. A recent Willis Towers Watson study in Germany re-affirmed this ongoing issue. In fact, the purchase price adjustment for underfunded pension liabilities are significant — sometimes as much as 10% or more.
The purchase price adjustment for underfunded pension liabilities are significant – sometimes as much as 10% or more.
However, good preparation can limit or even mitigate the financial risk pensions might have on a deal. For example, many companies are in transitioning from defined benefit (DB) pension plans to defined contribution (DC) retirement plans, by means of de-risking or buying out plans.
In this article, we provide some considerations and guidance for selling all or a part of a business that may have pension liabilities.
Five key learnings from our experience
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01
Be clear in the sales and purchase agreement how a purchase price adjustment is calculated so there is no room for interpretation.
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02
Ensure an understanding of the retirement plans, including the financials (i.e. accounting impacts local and global, including settlements/curtailments as well as ongoing costs) and plan documents.
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03
Know the plan structure and where decision making lies, including possible employee consultation (e.g. trustees, works councils, etc.).
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04
As the seller, explore options to de-risk pension liabilities prior to deal close and/or transfer the relevant liabilities to the buyer.
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05
Have a plan B: what happens if the entity is/isn’t divested? Do you have time to do all of this, and will the buyer cooperate with your approach?
Where are the company liabilities?
Many companies have a reasonable overview of where their most material pension liabilities lie. For larger groups of employees, liability thresholds are generally met and are included in the general International Financial Reporting Standards (IFRS) or the company’s U.S. Generally Accepted Accounting Principles (GAAP) accounting report. However, when selling smaller segments, identifying the corresponding pension liabilities can be a challenge because they are small in the overall context of the broader organization, even though they are material in the context of the specific deal.
Several questions that need to be asked when selling a business, including:
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What would the impact on liabilities be if a re-assessment were done at the current date (or deal close)?
Financial results are based on current market conditions, and relatively small market movements can have a significant impact on assets or liabilities, and hence the purchase price adjustment. For example, the initial COVID-19 outbreak caused large increases in net liabilities.
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What has changed since the valuation date that could affect liabilities?
Has the existing plan undergone any changes and do you have all documentation readily available? Has the population changed significantly (other than general experience) or have there been (or is there expected) legislative or regulatory changes that may be of impact? One such example is the recent U.K. Guaranteed Minimum Pension (GMP) court case, which could also change the value of a liability and would not be reflected in the current valuation, nor most roll-forward estimates.
Besides pension plans, there are quite a few other types of plans that provide a long-term promise to an employee, creating a liability.
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Which plans could generate a liability?
Usually, companies can identify their key pension plans, but besides pension plans, there are quite a few other types of plans that provide a long-term promise to an employee, creating a liability. Examples of these are termination/retirement indemnity plans (statutory in, for instance, France, Saudi Arabia, Turkey, the United Arab Emirates and in many other countries in Asia Pacific and South America), post-retirement medical plans (common in the U.S.), or jubilee or long service award plans, which can be found across almost all countries in the world. While this list is not comprehensive, all of these plans create a liability under most, if not all, accounting standards. Again, these can be small in the overall context of the broader organization, even though they are material in the context of the specific deal.
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Which plans are backed by assets (or insurance) and how much of these assets will transfer at close?
This is specifically relevant if the plans are multi-employer or otherwise combined with other not individually identifiable assets. A third party (such as a trustee or insurer) may have a say on which assets are included in a transfer — knowing where you have this authority and where not is crucial.
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Will any of the potential buyers have a different view on what constitutes a material liability?
While it is possible to identify liabilities under IFRS or U.S. GAAP, the buyer may use a different reporting standard than yours and as such certain liabilities may or may not require reporting. Multi-employer plans are a great example of this. They are not accounted for under U.S. GAAP (seen as DC plans) but may require accounting under IFRS. In addition, materiality is heavily dependent on the size of the business and needs to be considered in context.
Which liabilities to include and whom to include?
Once you have identified the employee liabilities in the transaction, a more strategic discussion arises. For example, which liabilities should be included in the transfer and which approach should we prefer as a seller? Which groups of liabilities — active employees, past service for active employees, vested deferred members, pensioners, etc. — do we want to include and must be transferred in the transaction? The structure of the deal (asset vs. share deal) will have an impact on this, but so can the legal structure of the sale.
In a share deal, if the existing entity has mixed plans and liabilities with other plans, it may be worth separating the assets and liabilities not just in relation to active employees, but also in relation to the vested deferred members and pensioners who have historically belonged to the entity.
De-risking opportunities have proven to be very lucrative for the seller at certain moments in time.
If past liabilities remain with the seller, would it be better to eliminate them from the balance sheet entirely or decrease the risk associated with them? This can be done by means of a buy-out of a certain group or the whole population. De-risking opportunities have proven to be very lucrative for the seller at certain moments in time, especially when insurers have not yet adjusted for market movements. However, it is important to evaluate whether it is more cost-effective to transfer these liabilities over to the buyer.
Which assets will transfer?
Pensions can be financed in many different ways, all of which carry different opportunities and risks. Legacy plans are most often funded on a collective level, therefore the exact backing asset value for an employee is not found individually and will likely require negotiations with the buyer and pension fund’s boards. In cases where these values are accrued individually, the situation is likely simpler, although the risk for true-ups in case pensions are financed, for example in a pay-as-you-go system, may still apply and should always be considered.
In the case of an underfunded pension plan, a sale of the business can trigger an immediate cash need, which may be required by law. In case of separation from a larger trust, where the buyer receives assets in line with transferring liabilities, trustees may require a true-up of liabilities on deal close to avoid the reduced remaining population having to compensate for the financial gap retained by the seller’s plan.
On the other hand, in cases where plans are overfunded, it may be worth considering a buy-out to realize the excess assets to the company prior to deal close.
If plans are insured, asset-transfer discussions are likely to be more limited, as the insurance contract itself should transfer with the deal.
If plans are insured, asset-transfer discussions are likely to be more limited, as the insurance contract itself should transfer with the deal.
Purchase price adjustments — limiting the risks
All of the above can result in suggested purchase price adjustments if necessary during the due diligence phase. As a seller, many risks can be limited and mitigated by having a clear understanding of what plans are in place, together with a clear view on what the preferred outcome should be. Making these strategic decisions ahead of due diligence ensures your M&A playbook is ready from a pension perspective, and you will be able to navigate through any difficulties that may arise during the sale of your business and optimize profits.
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