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As pension funds consider investing more in private equity funds, they may be tempted by the strong performance of investors such as the Yale University endowment. According to an article in Telegraph.co.uk, the endowment has generated a compound annual return from its private equity investments of 39.5% over the past 10 years.

So, should pension funds try to imitate such successes?

Yes, says the British Private Equity and Venture Capital Association (BVCA). “A lot of private equity funds are currently raised from US pension funds – it would be good to see further involvement from UK pension funds.”

Yes, but with caution, says Watson Wyatt Investment Consulting, leading pension investment advisors, in a new publication entitled private equity explained. The consultants warn that if pension funds’ governance arrangements can’t facilitate the identification of and access to superior private equity firms, they should not invest in private equity.

One point emphasised by Watson Wyatt is that private equity is the most expensive investment option in terms of fees paid to fund managers.

And now may not be the right time to invest in the private equity buyout sector. Said a senior Watson Wyatt investment consultant: “Recently private equity has turned from a cottage industry practiced by a few smart players … into a phenomenon that in certain areas is taking on bubble-like proportions. Investors are naturally starting to ask whether this exuberance is sustainable and what they can expect from the industry going forward.”

According to Telegraph.co.uk, Watson Wyatt’s worry is that private equity firms are taking on record levels of debt, and easy credit has led to leverage structures that are incomprehensible. Any significant hiccup in the economy is likely to cause major problems for a few private equity firms. And, in the short-term, returns on investments will probably decline.

Huge amounts of money are flowing into private equity buyout firms, which are competing for a decreasing number of companies to take over. That has caused acquisition prices to soar, with private equity firms borrowing ever larger amounts to stay in the race.

Premiums on UK mergers and acquisitions during the first half of this year, as measured by the per cent by which the price offered for a company’s shares exceeds their quoted price, are reaching levels not seen since the height of the dot.com speculation bubble in March 2000, reports TIMESONLINE.

Although some economists feel that the present M&A frenzy still has some distance to go, pension fund trustees should be urging caution at the present time.

And trade union-backed trustees will in any case be concerned about the social consequences of the debt being dumped on target companies, as well as the often scant paid to jobs and conditions as PE-backed managers go about stripping out costs - including company pension schemes.

Pension schemes as victims of PE restructuring

The risks for the pension schemes of companies targeted by buyout bids are twofold. First, private equity takeovers often saddle companies with a large amount of debt, increasing the risk that a company pension scheme may go into default later on. Second, the new owners may replace an existing company scheme with a less favourable one. That usually means abandoning a final salary, defined benefit scheme, under which retirees are guaranteed a specified monthly income.

The trustees of a targeted company’s pension scheme have important responsibilities in leveraged (debt-financed) takeovers, including those involving private equity firms.

At the beginning of this month, the UK Pensions Regulator issued a clearance guidance reminder to parties considering corporate transactions, such as mergers and acquisitions. Obtaining a clearance statement from the Regulator is voluntary. But it should be considered, said the Regulator, where a highly leveraged transaction occurs or where the assets available to a pension scheme are being removed from the employer group (e.g., asset stripping). In such cases, clearance is appropriate, irrespective of the pension scheme’s current funding.

Not applying for clearance or its refusal by the Regulator does not prevent a corporate transaction. But having a clearance frees the parties from certain possible regulatory measures later on. Those reportedly include making the parties, including the trustees, personally liable for a shortfall in a pension scheme’s funds.

In its reminder, the Regulator also said trustees facing such corporate transactions should consider whether to seek “a materially enhanced level of mitigation”. That means that while M&As are being negotiated, pension fund trustees should consider demanding upfront payments into a company’s pension scheme, in order to help safeguard the employees’ retirement benefits.

The Regulator said its reminder also applied to corporate transactions that might result in the abandonment of a pension scheme, which “is unlikely to be in the members’ best interests".

The Regulator’s text is sketchy and technical. But it did elicit some interest from the business press. The Financial Times saw it as a “pensions setback for leveraged buy-outs”, while Reuters said the UK pension watchdog was urging “tough trustee negotiation”.

The FT said the move would be seen as tacit endorsement of the trustees of Sainsbury’s, the UK supermarket chain. Faced with a private equity consortium bid, they insisted on a £2 billion payment to cover a pension scheme deficit that, in accounting terms, was less than £500 million. That demand was one major cause of the takeover bid’s failure.

One FT commentator welcomed the UK Regulator’s “attempt to put steel in the backbone of pension trustees”, adding that “bidders have shown a surprising nonchalance about the challenge posed to their bid arithmetic by pensions. In part, that reflects the inadequacy of accounting standards that mask the potential liabilities of pension funds.”

But pension scheme negotiations have not stopped Europe’s biggest leveraged buyout. Last month Alliance Boots, the UK pharmacy chain, was acquired by US equity firm Kohlberg Kravis Roberts, although talks with the pension scheme trustees were still going on.

The Regulator’s action comes amid a surge of high-debt bids for UK companies, and conflicts and concern over the consequences for pension schemes.

Among the cases mentioned in a recent article for Telegraph.co.uk is the AA, an automobile services company. It was acquired by a private equity consortium in 2004, and a year later it closed its final salary pension scheme to new employees.

Debenhams was bought by a private equity firm in 2004. Two years later, the department store chain replaced, for all employees, its attractive final salary scheme, just weeks after senior management pocketed £23 million in bonuses when the company was re-sold on the stock exchange.

Last month, also reports Telegraph.co.uk, hundreds of workers at Airwave threatened strike action, claiming that Macquarie, a private equity firm and the new owner of the UK police radio business, misled them when it scrapped their final salary pension scheme, to be replaced by a new defined contribution plan.



Sources: Watson Wyatt Press Release: “Private equity under the microscope”, 8 May ‘07; Tom Stevenson: “Pensions alert over private equity”, Telegraph.co.uk, 10 May ‘07; Josephine Moulds: “BVCA chief rebuts fears of ‘bubble’”, Telegraph.co.uk, 15 May ‘07; Christine Selb: “Equity firms force up bid target premiums”, TIMESONLINE, 15 May ‘07; Pensions Regulator Media Centre: “Regulator issues reminder on clearance guidance”, 3 May ‘07; John Greenwood: “Is private equity putting the boot into pensions?”, Telegraph.co.uk, 30 April ‘07; Norma Cohen: “Pensions setback for leveraged buy-outs”, FT.com, 2 May ‘07; Lombard, FT.com, 2 May ’07; Laurence Fletcher: “UK pension watchdog urges tough trustee negotiation”, Reuters, 3 May ’07; labourandcapital.blogspot.com, 3 May & 9 May ’07.