Risky business

Financial risk considerations are vital to successfully managing pension plans, especially for private equity firms with potential U.S. targets or portfolio companies that sponsor these types of plans.

The market uncertainty spawned by the recession has only aggravated the volatility inherent in most plans -- a situation complicated by the more stringent funding requirements of the Pension Protection Act. This causes many plan sponsors to reevaluate their financial management policies.

Compared with corporate pension sponsors, PE firms have some unique concerns regarding the risk management of their defined benefit plans. First of all, most pension sponsors support the view that equity returns will outperform fixed-income vehicles in the long run, but over the short term more typical of a portfolio company holding period, the expectations are not as compelling. Portfolio managers need to decide whether the potential for higher returns is worth the risk produced by short-term volatility in traditional pension investment strategy.

Second, the equity risk premium inherent in most pension investment allocations is credited before it is earned under U.S. generally accepted accounting principles, or GAAP. The accounting rules that cause this equity bias are not as important to PE firms that are usually focused on cash and balance sheet realities. The pension balance sheet should be the core metric for risk management and the benchmarking of success or failure.

Lastly, PE buyers must also consider that continuing equity exposure in the pension plan usually gains exposure to a generic market beta. This effectively dilutes additional returns anticipated by the purchase of the portfolio company -- and compromising the financial objectives of the deal.

For private equity firms, liability-driven investing, or LDI -- an investment strategy set with explicit reference to liabilities -- is crucial. At one extreme, plan sponsors use LDI to eliminate as much risk as possible. At the opposite extreme, sponsors use LDI to redeploy risks in search of higher returns. The common theme among sponsors using LDI is that they don't look at asset performance in isolation. Rather, they incorporate characteristics of the liabilities and objectives of the enterprise into the analysis to deploy risk more wisely.

For example, while cash may be the least risky asset in an asset-only world, the volatility of pension liabilities resulting from interest rate movements results in liability risk that is increased by holding cash. Given the shorter time horizons in the exit strategies of many PE buyers, and the significance of pension deficits, the liability-driven perspective is critical to the ongoing management of the pension plans they acquire. At a minimum, PE buyers should use LDI techniques to value the pension risks to which they are exposed, and many may be highly motivated to reduce or minimize this risk.

Since the start of 2009, the average plan's funded status has recovered significantly, mostly due to increases in long-term corporate bond rates that drive pension liability values -- though some of these gains have been given back recently. Plan sponsors reluctant to "sell at the bottom" may wish to reconsider when taking a holistic view of plan management and accounting for the impact of interest rates on plan liabilities. While "selling at the bottom" may present some attractive buying opportunities for asset classes such as long credit, there is also the additional advantage of reducing pension liability risk exposure.

Given all this, there should be a strong motivation for private equity funds to begin to take pension risk off the table for their portfolio companies. PE firms with material pension obligations within their portfolios should be conscious of this exposure and the potential implications on fund performance. They should be proactive in tailoring their risk management strategies to their unique needs.

In summary, a heightened emphasis should be placed on this analysis during due diligence. The shorter horizon to exit is often at odds with the longer-term perspective adopted by portfolio companies, resulting in an even stronger imperative to de-risk these plans. Indeed, the pension strategy of portfolio companies rarely aligns with the objectives of private equity buyers.

But in the current environment, PE firms have a stronger incentive than ever to adopt a liability-aware perspective.

Scott Allen is a principal and actuary with Mercer LLC's private equity mergers and acquisitions business. Richard McEvoy is a worldwide partner and senior consultant and actuary in Mercer's New York office retirement, risk and finance business.