January 17
GKN Trustees try to put Melrose (back in their) Place

Yesterday the Trustees of the GKN Group pension schemes took the unusual approach of issuing a press release highlighting the potential impact on their pension schemes of a hostile takeover of GKN plc, a multinational automotive and aerospace components company, by Melrose plc, a turnaround company focusing on the manufacturing sector. Their aim seemed to be to highlight that, if the hostile takeover took place, there would be a material pension deficit to be repaired by the new owners.

GKN plc has two UK DB pension schemes – the GKN Group Pension Scheme 2012 (the ‘GKN 2012 Scheme’) and the GKN Group Pension Scheme 2016 (the ‘GKN 2016 Scheme’). GKN’s 2017 interim results show a combined deficit of £1.063bn at 30 June 2017 under the accounting standard IAS 19, based on assets of £2.367bn and liabilities of £3.430bn. This compares to a market cap of £5.6bn at the same date, demonstrating that these pension schemes are a substantial obligation for GKN. (The market cap was relatively unchanged at £5.5bn at the end of 2017, although this had increased to £7.6bn at close of play on 16 January 2018 following news of the potential takeover.)

GKN have historically taken some proactive steps to manage their DB pension liabilities, perhaps in an attempt to reassure the markets given the size of the schemes. A series of pensioner buy-ins have been completed, to transfer some liabilities to insurers, and a pension increase exchange (‘PIE’) exercise was completed in 2015. Perhaps most materially, an asset backed contribution (‘ABC’) arrangement was put in place in 2011, intended to provide cash contributions of £30m pa over two decades. (This was initially included as an asset of the pension scheme, but following an investigation from the Financial Reporting Council (FRC) the terms of the ABC were changed, meaning it is no longer recognised as a pension scheme asset. This reduced the pension scheme's disclosed assets by £342m. More details of this are available in our previous blog, ABC Demolition Derby?.)

GKN also took the unusual step in 2017 of issuing debt specifically to reduce their pension scheme deficit. A £300m 15 year bond was issued, at an interest rate of 3.375% pa, of which £250m was injected into the pension schemes in October 2017. Further detail on this was contained in our March 2017 blog, GKN –renaming your pensions debt.

The statement which the Trustees issued yesterday included details of the consolidated funding position of the two schemes on three measures, all of which include retrospective allowance for the £250m contribution paid in October 2017 (which was not allowed for in the accounting liabilities disclosed at 30 June 2017). The calculations also make no allowance for the value of the ABC, given that its structure means it is not recognised as an asset of the pension scheme, as noted above. The figures are as follows:

·         Solvency deficit of £1.9bn at 30 September 2017;

·         ‘Gilts flat’ deficit of £1.1bn at 30 September 2017; and

·         Accounting deficit of £0.8bn at 30 June 2017.

While these are interesting figures, in my view the most relevant figure is notable by its absence – the deficit on the ongoing funding basis agreed between the Trustees and the Company as part of the latest triennial valuations.

The latest triennial valuations were completed as at 5 April 2016 and 31 December 2016, for the GKN 2012 Scheme and the GKN 2016 Scheme respectively. These had not been finalised when GKN’s 2017 interim results were published in July 2017, but appear to have subsequently been completed, when the £250m lump sum was paid and the Schemes were also closed to future accrual. (As part of their efforts to win over shareholders as part of their hostile takeover bid, Melrose have suggested that GKN’s management were too slow to close the DB scheme and that they would have done so far earlier.) The 2017 interim results state that GKN expect that as part of the finalised valuation their deficit contributions will reduce slightly from the current level of £42m pa from 2018. This suggests that the ongoing funding deficit will be materially lower than the three figures quoted by the Trustees in their press release.

So why did the Trustees’ press release omit details of the deficit on the ongoing funding basis? I expect this is because the Trustees do not consider that the deficit on the current funding basis would be relevant after a Melrose takeover. They expect that the takeover would weaken their employer covenant, requiring them to adopt a more prudent funding basis in future, perhaps closer to the ‘gilts flat’ basis mentioned in their press release.

In their announcement to the stock market on 17 January 2018, setting out their latest offer to the shareholders of GKN, Melrose reconfirm that if their takeover is successful they would expect to put in place group net leverage of around 2.5x the EBITDA of the enlarged group. By comparison, GKN’s net debt at 31 December 2016 was 0.7x the 2016 EBITDA figure for GKN. It therefore appears that there would be a substantial increase in leverage if the Melrose takeover occurs.

As demonstrated by the Carillion case earlier this week (see my Carillion collapse causes covenant catastrophe blog for more detail), introducing debt is usually detrimental to the employer covenant of a pension scheme. Secured debt would usually rank ahead the claim of a pension scheme (typically an unsecured creditor), while the cost of servicing the increased level of debt also reduces the cash which might otherwise be available to contribute to the pension scheme.

If the employer covenant is weakened materially by the transaction, the Trustees (and the Pensions Regulator) would expect mitigation to be provided to the pension schemes. Options include cash or security over an asset of the business. While the Trustees would not have the power to block a transaction if such mitigation is not provided, the new owners would be taking a substantial risk that the Pensions Regulator might intervene at a later date and attempt to use the moral hazard powers against the new owner or its directors. Further, given that the Trustees have control over the investment strategy of a pension scheme, and in some cases have a power to wind-up the pension scheme, a hostile relationship between trustees and the owner of a business can lead to material ongoing difficulties for management.

In addition, given that this transaction would involve listed entities, the requirements of the Takeover Panel apply, which should help to ensure the Trustees have a voice in the process. See our previous blog Trustees given seat at table in debating potential takeovers for more detail.

However, in their announcement of 17 January 2018, Melrose stated that the figures provided by the Trustees were “entirely in line with Melrose’s own reading of the pension exposure at GKN and Melrose looks forward to meeting the trustees as soon as is appropriate”. Indeed I would find it very surprising if Melrose had not taken detailed pensions advice as part of their due diligence, particularly as they have previously been involved in the acquisition of businesses with material DB schemes (notably the acquisition of FKI plc in 2008). I therefore expect they should be fully aware of the pension implications of materially increasing leverage post acquisition.

While public statements of this sort from the trustees of a DB scheme are rare, the tactics have been employed before in an apparent attempt to deter a potential suitor. For example, in 2007 the Qatari backed investment fund Delta Two dropped a takeover bid for J Sainsbury following proclamations from the trustees of its pension scheme, who had demanded a cash injection of £1.75bn as part of any deal, due to expected increases in leverage.

It remains to be seen whether the Trustees’ statement will have any impact on the success of Melrose’s attempted takeover. However, given the current high profile nature of DB pension schemes, and the recent failures of some household names with large pension schemes, I do not find it surprising that the Trustees of the GKN schemes are keen to go public about the steps they will take to protect the security of their members’ pension benefits.


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