The importance of benefits and reward during mergers and acquisitions

With many a merger and acquisition floundering on the basis of benefits’ liabilities, Clare Bettelley puts together an action plane to help avoid M&As being scuppered

Executive Summary
• Some 50% of M&A deals fail because of employee benefits and the differences in the reward arrangements between the two firms.
• Shares are commonly used to lock in key staff, and best practice dictates that they are performance-related, based on value that is created post completion of a deal.†
• FDs of both firms need to undertake a cost benefit analysis of their rewards, with the FD of the acquiring firm simultaneously identifying possible synergies between the two frameworks and to work out if they need to put in extra resources.
• FDs should consider integration in the context of whether it will create a fair reward structure, in addition to determining whether the benefits outweigh the cost of the process. A nightmare scenario is to harmonise up, where all staff within the merged entity move on to the more generous reward scheme of the two companies, thus increasing the cost of the deal.
• FDs of acquiring companies must know the latest funding position of the pension scheme of a target company, the accounts, and any promises made to members concerning their contributions at the first stages of deal negotiations.
• Flexible benefits can be used to reduce any difference between the benefits packages of merged firms.

One of the primary reasons for the failure of a merger or acquisition is the lack of attention to employee benefits. As Duncan Brown, director in the human resources practice at consultancy firm PricewaterhouseCoopers, says: “Everyone knows that at least 50% of M&A deals fail because of this, so finance directors need to look at total costs, the size of integration work and the differences in the reward arrangements between the two firms.”

Of course, the worse case scenario resulting from the neglect of the non-financial issues (such as human resources) is the collapse of the deal, as private equity firm Permira and investment vehicle Delta Two know only too well – pension funding agreements scuppered their attempted takeovers of WHSmith and J Sainsbury, respectively.

The first port of call for any M&A deal-embroiled FD worth their salt is to engage with HR peers and help identify the key staff they wish to retain. And this does not just relate to executives. For example, a pharmaceutical firm is likely to value its scientists more than its executives, particularly if they are in the advanced stages of research and development for a new drug.

Terry Simmons, head of Ernst & Young’s new pensions advisory team, says FDs should consider the cost impact of locking in key staff. The length of lock in will depend on role: a financial controller may be key to overseeing the running of a business, but is ultimately replaceable, whereas a head of R&D in a technology business may be hard to find.

So, it’s important for companies to know who they can afford to lose from the outset, before tackling cost reduction. As Simmons says: “It’s about understanding the nature of your business and thinking about how much it will cost to replace key members of your team – both in terms of direct cost and lost sales or production. Lock-in could be good value.”

It is equally important to keep all existing staff informed about any departures. Charles Cotton, reward adviser for the Charted Institute of Personnel and Development (CIPD), explains: “There is a tendency for organisations to only want to point out good, rather than bad news. “It is important to strike a balance – if there are going to be redundancies, it’s important to indicate that as soon as possible. Employees will fill the vacuum with rumour and innuendo, which may be far worse.”

In terms of retention strategies, shares are commonly used to lock in key staff, and best practice dictates that they are performance-related, based on value created post completion of a deal. Indeed, this is an approach believed to have contributed to the ongoing success of the acquisition strategy adopted by insurance giant, Aviva.

Special or ‘transaction’ bonuses, which reward staff on completion of a deal but are not linked to performance, are less common. Egg UK is an exception to the rule. Its 20-strong UK management team that were in place in 2004 were each awarded an average £50,000 windfall in the form of a ‘loyalty bonus’ when its then majority stakeholder, Prudential, first announced its intention to sell off the business – despite the sale not going ahead.

All remaining Egg UK staff shared a loyalty bonus worth more than 50% of the company’s £6.4m transaction costs incurred in 2004, not including the £1m shared by management.

At the time, Kieran Coleman, group financial controller of the internet bank, which was finally sold to Citigroup for £575m in January 2007, said that the board took a quick decision to pay the bonus, with actual amounts based on length of service. He added that it “absolutely served its purpose” as far as shareholders were concerned because it retained staff.

But transaction bonuses are generally discouraged. Marcus Peaker, chief executive of Halliwell Consulting, says: “From a corporate governance perspective, deal bonuses are not best practice. Doing a deal doesn’t necessarily mean it is a good deal – it doesn’t necessarily offer value to shareholders.”

Mark Hoble, principal in Mercer’s human capital business, agrees: “What matters is not the transaction, but delivering value post the deal.”

He adds that in addition to share incentives delivering value, cash bonuses may be considered for small teams. But he warns that this is not necessarily the best strategy for ensuring staff retention and thus the success of the deal because most share plans pay out on change of control. “Share plans can vest and when the market’s more buoyant than it is now, people can make vast amounts of money. So it’s not enough to think you can throw money at staff to retain them – there has to be a more challenging proposition put forward, such as freedom of movement in their role where a chief executive is concerned,” explains Hoble.

PwC’s Brown says FDs of both firms next need to undertake a cost benefit analysis of their rewards, with the FD of the acquiring firm simultaneously identifying possible synergies between the two frameworks. “The question for the acquiring firm is, do we want to acquire this company? If yes, will we have to put a lot of resources in to do so?” he adds.

“Then consider how to approach integration – the nightmare scenario is to harmonise up.” This would involve moving all staff within the merged entity on to the more generous reward scheme of the two companies, thus increasing deal costs.

The integration of reward schemes is not necessarily required to achieve harmonisation among staff. FDs should consider integration in the context of whether it will create a fair reward structure, in addition to determining whether the benefits outweigh the cost of the process. The existence of two employees performing the same role but on different benefits – of course, in the absence of a flexible benefit scheme – should be avoided.

Cotton says: “If you upset employees in both organisations you’re going to have problems. It’s about consistency and fairness. If you’re taking over a firm, you’ve got to keep the wheels on the road going.”

‘Harmonising up’ might only mean a few thousand pounds more in terms of a company car allowance, but it could result in a multi-million pound increase when it comes to pensions contributions, particularly where a defined benefit (DB) scheme is concerned.

For most companies, pensions constitute the most onerous liability on their balance sheet. Take Alliance Boots, which was acquired by private equity firm Kohlberg Kravis Roberts (KKR) last year in Europe’s largest ever leveraged buy out. Its IAS 19 pension liabilities totalled a whopping £3.5bn as at 31 December 2006, up from £3.1bn in 2005.

Of course, pensions are not necessarily valued by staff any more highly than other rewards on offer, particularly among younger staff members. But they have been thrust into the limelight of M&A deals involving listed companies in recent years, thanks to FRS 17 and its successor International Accounting Standards successor, IAS 19, which require listed companies to recognise in full their pension fund deficit or (recoverable) surpluses on their balance sheets.

And given that the UK’s top 200 companies had a combined DB deficit of £41bn at the end of 2006, according to data from Aon Consulting, the sums became a glaring entry on their organisation’s balance sheets.

The size of a target company’s deficit and the corresponding annual contributions required can impact upon the price an acquiring company is willing to pay to for the deal, and indeed whether it is prepared to pursue it – something Arcadia group owner Sir Philip Green knows only too well. Marks & Spencer’s pensions trustee chairman, David Norgrove – now chairman of The Pensions Regulator – blocked Green’s takeover of M&S in 2004 after claiming that Green would have to stump up annual contributions of £785m, rather than the £105m first thought, as part of the funding agreement for the company’s pension scheme. Needless to say, it sunk the deal.

David Farmer, a partner and head of pensions at law firm Beachcroft, says that FDs of acquiring companies must know the latest funding position of the scheme of a target company, the accounts, and any promises made to members concerning their contributions at the first stages of deal negotiations. And this is regardless of the date of a fund’s last triennial review. “Actuarial calculations are pretty strong, so they can afford to do a back of an envelope calculation,” says Farmer.

But pension liabilities, regardless of whether the fund is in surplus or deficit, are a movable feast, primarily due to actuarial variations. Valuations calculate the value of a fund’s assets and liabilities based on its investment strategy, mortality, inflation and life expectancy assumptions, and scheme members’ earnings.

Differences in the estimated value of a fund arise because of the range of data used to calculate each variable, and this confusion is compounded when assumptions are not updated. For example, Alliance Boots’ IAS 19 deficit was based on mortality assumptions, which had not been updated since 2004.

In a research note on the Alliance Boots/KKR deal last April, independent pension consultant, John Ralfe, states: “Boots’ mortality assumptions are weaker than Sainsbury’s, Tesco, Morrisons and Marks & Spencer.” Furthermore, there is no allowance for future expected improvements – the so-called “cohort” effect,” which refers to the rate of increase in life expectancy of scheme members.

Ralfe explains that a medium cohort improvement would have added two years to Boot’s current longevity assumptions (83 for a man and 85 for a woman), which added around £280m to liabilities, increasing Alliance Boots’ September 2006 IAS 19 deficit from £83m to over £350m.

A further conundrum for FDs is the basis upon which to value fund deficits. Acquiring FDs need to ascertain a realistic deficit total, and to do this they must decide whether to base the calculation on an FRS 17 or a buy out basis. Farmer says the gulf between the two can be gigantic.

FRS 17 and IAS 19 calculate pension funds as a going concern and are based on fund members’ projected salaries to retirement. They require pension assets to be marked to market value and liabilities discounted at an AA corporate bond rate. The latter is often criticised because, in theory, there may be no corporate bonds long enough to match scheme members’ pensions. Conversely, buy-out valuations are based on the scheme closing and so reflect scheme members’ current salaries, and involve the calculation of the total cost of offloading the pension scheme(s) assets and liabilities from the balance sheet into the hands of an insurance company, such as buy-out specialist Paternoster. This involves pricing the liabilities and all associated risks of the scheme for the length of scheme members’ lives.

Farmer says: “I think a buy-out basis is incredibly conservative. There is a huge risk of creating a fund surplus if a company has no intention to wind up a scheme. Also, it might not be paying pension benefits for years.”

Hence the consideration of back-end loaded recovery plans, which would involve pension contributions increasing over time, according to the needs of a scheme, instead of The Pension Regulator’s favoured 10-year recovery plan.

Farmer says: “They are do-able, and there’s usually a charge over property or a parent company guarantee sought. Then, you can make meaningful changes in the scheme, in terms of mortality and investment assumptions and salary rises.”

Of course, from a pension trustee’s perspective, there is concern about whether they may lose their window of opportunity for funding if they agree to a back-end loaded plan. This is particularly the case with highly leveraged private equity deals – pension trustees of takeover target funds often fear that private equity firms’ requirement to satisfy their investor and bankers’ interests will be at their expense should they require funding following the buy-out.

Alan Smith, director of First Actuarial, also questions the potentially detrimental effect of highly leveraged deals on fund investment strategies. “If trustees have a sponsoring employer with a lot of debt on its balance sheet and little free cash flow due to the need to repay the debt, then the trustees will be under pressure to take a more conservative approach to their investment strategy,” he says.

This is because trustees can’t rely on the employer being able to increase contributions if, say, an equity-based investment strategy resulted in a fall in the value of a scheme’s assets. Smith adds: “So, following a leveraged buyout, trustees may shift some or all of their equity assets into gilts. In turn, given that the expected long-term rate of return on gilts is lower than it is on equities, this results in liabilities being discounted at a lower rate and hence having a higher value. In other words, the funding level is reduced.”

Other pension considerations include whether to apply to The Pensions Regulator for ‘clearance’ for an M&A deal and whether an FD should retain their position as a trustee in the event of an M&A, which poses an obvious conflict of interest.

In terms of the integration of reward schemes on completion of a deal, the consensus is that it’s about what makes sense for the merged entity. Harmonising down clearly creates tensions and, as the CIPD’s Cotton says: “It could be best [to leave] sleeping dogs lie.”

For example, when considering the integration of benefit plans, all of the benefits have to be considered. Mike Ashton, a senior consultant with Watson Wyatt, says: “Start with benchmarking. How much should you be providing for each part of the benefits package, such as pensions, cars, life assurance and so on? While looking to harmonise benefits you may have to ring-fence certain existing levels of benefits for particular employee groups however new employees could start on a standard package.” Ashton says the introduction of flexible benefits to reduce any differences could then be considered, so £30,000 plus pensions contributions, holidays, private medical insurance (PMI) and life assurance equates to £30,000 plus £7,000 to spend on flex.

He adds that the key message is: “By converting benefits into their cash value and providing a menu of benefits, you then create equal access without necessarily increasing costs. This enables the focus to move to total cash rather than simply differences in particular benefits.”

The integration of PMI schemes may not be so easy. Rachel Dineley, an employment partner at Beachcroft, says: “FDs will have to consider the implications of the nature and extent of cover, particularly where claims are in the process of being considered. For example, a business where an individual has had a very serious illness might find this condition excluded under the new plan, which means that the individual would be completely stuffed.”

As would FDs who neglect the human element of an M&A deal. As the CIPD’s Cotton warns: “This often gets overlooked in all the excitement of mega money deals. The danger of this, of course, is that staff vote with their feet and bugger off, which means you’ve bought an organisation not worth very much.”

Key tasks for FDs when tackling mergers & acquisitions
• Assess what resources are required to ensure the deal is a success and, based on this, whether you still want to pursue it
• Identify key staff and devise rewards to lock them into the new company
• Benchmark existing rewards
• Survey the value staff place on existing benefits
• Quantify the cost of existing benefits
• Consider the impact of changing/removing/creating new reward schemes
• Assess the costs versus the benefits of reward scheme integration
• Check whether pension fund actuarial reviews are up-to-date, and the basis on which they are valued
• Never underestimate the importance of communications during the M&A process and beyond (see box over) and co-opt senior ranking colleagues with staff messaging responsibilities to keep their focus




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