Sponsor transactions – Are trustees under a false sense of security?

Almost £133bn changed hands in UK M&A deals in the first half of this year — a 77 per cent year-on-year increase, according to MergerMarket.

The Pension Schemes Act 2021 has also driven a shift in behaviour, with engagement levels between sponsors and trustees ramping up.

With new criminal offences and provisions to widen the Pension Regulator’s moral hazard powers having recently come into effect on October 1 2021, but a new defined benefit funding code not expected until 2022, trustees are in a hiatus between old and new regulations.

With updated clearance guidance just issued by TPR, and M&A activity levels so high, now is a good time for trustees to revisit the contingency plans they have in place to deal with significant corporate events

TPR’s new transaction tests

Two new tests, on employer insolvency and resources respectively, make it easier for the regulator to impose a contribution notice. They are a useful framework to assess any potential detriment that arises out of transactions.

However, the tests only capture the impact on the sponsor today, even though there are many scenarios where the impact on member security and benefits will not be known until later.

It is important for trustees to have a holistic view on covenant. This can be done through pre and post-event covenant assessment, alongside consideration of the new contribution notice tests.

Trustees risk being lured into a false sense of security, given strong and improving funding levels across schemes as a result of the ongoing economic recovery.

These funding levels might mean schemes no longer have the natural leverage they once had when negotiating during transactions, as they arguably have less impact on a scheme’s covenant.

Schemes in surplus in a difficult position

Where schemes have a funding surplus, it is harder to justify a request for cash funding, even where a transaction results in meaningful covenant erosion. We see significant transactions that lack a relevant deficit, as defined by TPR, leaving trustees struggling to find a place at the negotiating table.  

Even with a well-funded scheme, trustees need to carefully understand changes in covenant risk profile. This is particularly the case if a scheme’s long-term funding plan and/or maturity profile means it will retain covenant reliance over a prolonged period until an end state is reached.

The act will require sponsors, trustees and their respective advisers to think hard about setting parameters for what might be considered ‘reasonable’ and ‘material’ within a scheme’s overall risk exposure.

For trustees, it is helpful to ensure sponsor directors are aware of the act’s provisions and have formally considered these as part of their assessment of a transaction.

Where trustees and sponsors agree that a transaction is not materially detrimental but covenant risk has increased, quantifying mitigation will be harder. This situation could ultimately prove helpful for putting in place arrangements to protect schemes’ longer-term journey plans.

‘Softer’ protections have a part to play

Over this longer time horizon, we see fewer examples of one-off mitigation payments and more of a focus on a package of measures that provide protection and clarity.

This might include security, though trustees of better-funded schemes must also consider the value they place on ‘softer’ protections, such as enhanced protocols for sharing covenant information and the relationship with the sponsor.

Non-cash solutions, including contingent assets, are useful tools to back a long-term funding plan, help protect trustees against hindsight risk and allow sponsors to preserve cash.

A broader mitigation package could include an enhanced information sharing protocol, improving trustee visibility over sponsor position and prospects.

With updated clearance guidance just issued by TPR, and M&A activity levels so high, now is a good time for trustees to revisit the contingency plans they have in place to deal with significant corporate events.

Trustees and sponsors may view transactions with confidence right now, but we already see winners and losers in the ‘post-Covid’ corporate world. Trustees should think about how a scheme sponsor’s sector is likely to fare in the recovery period, and plan for what could go wrong.

Hamish Reeves is a director of Cardano Advisory