A new research report, “The Market Value of Pension Liabilities”, produced by Punter Southall Transaction Services, the specialist M&A consultancy division of Punter Southall, has found that the UK public equity market does not appear to treat FRS17 pension deficits as a debt of the sponsoring employer, unlike the typical practice observed in UK private equity and debt markets. Instead the research, aimed at determining how the various UK capital markets price a pension obligation in respect of a defined benefit scheme, based on a review of existing academic studies and analyst research studies as well as interviews with market participants including equity analysts*, concluded that FRS17 deficits are probably not fully recognised in the UK equity market’s valuation of a company and that the UK equity market reacts indifferently to most pension related issues.

The fact that FRS17 deficits are not treated as the debt of a company has a number of significant implications. First, it results in a weakening of the market for corporate control with pension funds acting as a defence against private equity takeovers. Unlike the public equity markets, private equity markets do generally consider a pension deficit to be a debt of the sponsoring company - the research found that two thirds of investment professionals at private equity houses surveyed** had abandoned deals due to pensions problems. Second, executives with share options have an incentive to under fund their pension scheme knowing that the equity market will forgive a pension deficit but not a foregone dividend.

Paul Geeson, Principal at Punter Southall Transaction Services, commented: “The fact that UK equity markets may be failing to price pensions as a debt of a company is a very important consideration for any investor in equity assets. If FRS17 deficits are not fully recognised in UK equity market valuations of a company, then arguably there is a possibility that the shares of companies with a defined benefit pension scheme may be overvalued and as such, investors might be wary of investing in companies with significant deficits.

“For some investors, such as pension funds, there is an additional reason for avoiding such investments in that these companies are likely to suffer poor performance due to their large pension liabilities just when the pension scheme needs them to perform well. For others, however, companies with large pension deficits may prove to be an attractive investment opportunity (whether in a long or short position) if they believe the market is taking an incorrect view on the pension.”

Please click here for the full report.

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*The research is based on a review of existing academic studies, equity analyst research pieces and the views of market participants, including brokers, analysts and investment professionals at private equity firms.

**16 investment professionals from leading private equity houses regularly involved in UK transactions that contain pensions obligations were interviewed for this study.

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