S&P recently commented that private equity ‘dry powder’ growth had accelerated in H1 2024 against a backdrop of an improving M&A environment¹. Market commentators remain optimistic that a more sustained uptick in private equity backed transactions will continue through H2 2024 and 2025, with the market having seen a modest increase in deal activity in H1 2024.

The improvement in the funding level of UK defined benefit (DB) pension schemes may provide a further catalyst for M&A activity. Previously, large UK DB pension deficits were often a deal breaker. However, the significant rise in interest rates since 2022 has resulted in the majority of DB schemes moving from a deficit to a surplus. This has materially reduced (and in many cases, resolved) the pensions issue for companies. Not only that, but DB surpluses may also present a significant opportunity for investors to realise previously untapped upside – either through growing those surpluses further over time or by transferring the pension scheme to an insurer and removing it from the balance sheet.

In light of these trends and the emergence of new opportunities, we set out below three key takeaways for companies and private equity investors when considering M&A deals where a DB scheme is present.

1. Investment entry – Achieve the right pricing discount on entry and minimise pension risk

Schemes that are well funded are unlikely to need further cash contributions from the sponsor. Despite this, investors will still need to ensure that they achieve the right purchase price discount on entry and that any deal with the pension scheme is not unduly prohibitive or value dilutive. The discount is likely to reflect a more cautious valuation of the pension liabilities by the pension scheme trustees than that shown in the financial statements.

Alongside that, pension scheme trustees will need to ensure that the scheme’s position remains protected post any M&A deal. Where the pension scheme could be impacted by the deal, a purchaser will need to assess the need to provide ‘mitigation’ to the pension scheme. There are a broad range of non-cash solutions, and with careful planning, purchasers can ensure that any mitigation provided does not constrain the deal financing structure or portfolio company strategy, whilst also addressing the trustees’ concerns and supporting the investor’s objective of reducing the acquired pension risk.

2. Hold period – Put in place a pensions strategy that aligns with your investor objectives and timeframes

Where the company needs to retain the pension scheme for a period, it is more important than ever that investors use an M&A deal as an opportunity to reset and formalise a pension strategy with the trustees that aligns with their own objectives and timeframes. 

This will include working with the trustees to set a scheme funding and investment strategy, alongside defining the ultimate objective for the scheme. As part of this process, a framework should be established to determine how any potential future surplus could be shared between the sponsor and scheme.

3. Exit – M&A provides an opportunity to accelerate the pension scheme ‘end-game’

Where a scheme is well-funded, an M&A deal can provide the opportunity for the company and trustees to accelerate the process of transferring the pension scheme to an insurer. As with any transaction, there are a number of factors that impact the insurer’s price for acquiring a pension scheme, and understanding how best to position the pension scheme ahead of engaging with insurers can increase the return for the investor, whilst also securing pension benefits for members. It is key to identify the steps that need to be taken to maximise pricing benefits early to enable implementation during the investment hold period. For sellers, this could provide the opportunity to carve out the DB scheme before, or as part of, the broader exit process.

In summary, the DB pensions landscape has materially shifted over the last few years, and schemes are no longer the ‘deal breaker’ that deterred potential bidders in previous potential transactions. Careful and innovative planning can not only help to price and manage DB pension risk during M&A, but also enable the company to de-risk the balance sheet during the hold period to generate incremental value for the investor on exit.

¹ S&P, “Private equity dry powder growth accelerated in H1 2024”, 12 July 2024