Pensions: Employer covenant considerations during a refinancing

The events of recent years have put a significant strain on the finances of a wide range of companies.  They have dealt with Brexit, survived through COVID-19 lockdowns and managed global supply chain issues.  Now they need to deal with higher energy costs and the prospect of a significant spike in inflation and potentially higher costs and interest rate environment.  Some industries have been hit harder than others.

As a result, in the Deloitte employer covenant team we are seeing many requests from defined benefit pension scheme trustees and their sponsoring employers for assistance in assessing the employer covenant impact of their refinancing requirements.

For both trustees and sponsors the implications of refinancing can be significant and the Pension Schemes Act 21 (“PSA21”) brings with it new Pensions Regulator (“TPR”) powers and tests that are directly relevant to these circumstances.  In our experience, in all cases sponsors are acting with good intentions and business logic to secure financial support for their business on commercial terms and help ensure they can be successful in the future.  However, it is vital to consider the impact on the pension scheme.  Importantly, trustees need to be aware of the event and its rationale, be able to analyse the impact on the pension scheme and negotiate suitable mitigation where required.

Key considerations

Put simply, the pension scheme is likely to be a significant and important stakeholder in any company refinancing and needs to be treated as such.  By following the right series of steps for both the sponsoring employer and trustees, then the pension scheme’s needs can be properly taken into account and the security of members’ benefits preserved.

Some of the key questions to be asked and answered are set out below with some thoughts on things to consider for each question:

1.  What security is granted to the lender on the refinancing?

A crucial consideration.  Pension schemes rank as unsecured creditors, so if additional lending is placed on the sponsor, with the lender taking first ranking security, the position of the pension scheme is likely to be worsened.  This goes to the heart of the TPR’s new test known as the “Insolvency Test” – that is, if the sponsor were to become insolvent, is the pension scheme recovery likely to be worse following the refinancing than beforehand?

2.  What are the funds raised in the refinancing being used for?

Much current refinancing is being undertaken to replace and extend working capital facilities fully drawn through the pandemic.  Therefore, the purpose is to support the ongoing trading of the business.  In this scenario it is important to consider the offsetting positive balance sheet impact of the cash raised against the debt incurred – that is, the cash raised is used and deployed in the business over time.  However, trustees need to take care to understand if there is any leakage of this value such as through dividends, share buybacks, or other payments that effectively route funds out of the sponsor, weakening the employer covenant.

3. What would happen if the refinancing does not take place?

Essentially the sponsor may have little choice but to refinance if current facilities expire or if additional funds are required to keep the business trading.  The terms of that refinancing will largely be driven by the debt markets determining the security required, the interest rate payable and the repayment terms.  

However, most sponsors will have some choice from a range of products such as a secured revolving credit facility through to asset backing lending, to sale and leaseback arrangements.  The sponsor will seek to best optimise borrowing for their specific needs.  However, those specific needs should take into account the trustees and the pension scheme stakeholder.  The optimal product may vary in the presence of a significant defined benefit pension scheme.

4.  Is the prospect of the sponsor improved by the refinancing?

The short-term impact of the refinancing on the pension scheme is important, but arguably more important is the long-term prospects for the sponsor and the pension scheme.  As is often pointed out, pension schemes are very long-term endeavours and so the trustees will need to consider if the long-term potential benefits might outweigh shorter term impacts.  This is not an easy equation to balance, but a stronger long-term covenant is likely to be the optimal outcome.  This consideration is reflective of the need for the trustees to consider is there a “Material Detriment”.  This doesn’t stop the trustees seeking mitigation against short-term impacts but it does impact on the balance of power in any negotiation.

5.  What is the impact on the profitability of the Sponsor?

This brings us back to the TPR tests and in this case the “Employer Resources” test.  This test essentially looks at the impact on net profit of the sponsor of the refinancing and whether it is material in the context of a pension scheme’s buy-out deficit or Section 75 debt.  The refinancing may result in a change in the interest cost and hence profits; in addition, there will likely be fees and costs associated with the refinancing.  This needs to be considered in the TPR test and the impact understood.

Reaching agreement

Having asked and answered all the key questions and considerations, the trustees will need to agree with the sponsor the impact on the employer covenant and what needs to be done about it – the process of identifying the material detriment and the mitigation needed. 

But every situation is different and the individual circumstances and restrictions need to be recognised.  If too much mitigation is demanded the future employer covenant may be compromised and sponsor flexibility in running the business impacted.  Long-term this would not benefit the pension scheme, but equally too little mitigation might be regretted if the company goes on to fail.  A balance needs to be struck.

The role of the trustees is never easy and seeking the advice of an experienced covenant adviser is an important step to help the trustees come to a balanced and appropriate outcome, managing the security of members benefits in the short alongside the sponsor’s long-term prospects which of course underpins the long term employer covenant.

From the Regulator

Refinancing activity was the subject of a recent blog post published by The Pensions Regulator. In the article, David Fairs, Executive Director of Regulatory Policy, Analysis and Advice, set out the Regulator’s expectations of trustees and sponsoring employers in such scenarios.