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27 May 2021

Covenant case study: how to protect your recourse in a corporate transaction

Our case studies examine real life situations that bring to life particularly important aspects of covenant risk management, with an explanation of the actions taken and the outcome achieved. This case study looks at a situation where a scheme’s trustees were faced with a leveraged takeover bid for the sponsor company.

What was the situation?

Pension Scheme A was sponsored by a UK listed group and had access to the Group-wide covenant on an ongoing basis.

  • However, the Trustees had concerns about potential corporate event risks, including takeover, major disposals and demerger given persistent market rumours and undervaluation vs. peers.
  • Ahead of any such event arising, we worked with the Trustees to develop a “defence plan” which included the potential covenant impacts of various corporate event scenarios, what the Trustees might seek in these situations, as well as more practical aspects such as administrative and logistical preparations, governance and conflict management, action plans, and communication and PR considerations
  • These concerns were communicated to the company such that they understood the Trustees’ thought process and had early warning about potential concerns

  • Corporate event: the sponsor received a takeover approach through a leveraged bid structure.
What were the key risks?
  • The approach represented a material negative impact on the covenant, with the key risks including:
    • Increased leverage, which would lead to:
      • Lower free cash flow due to higher interest costs
      • Higher level of competing creditors
      • The risk of subordination
    • Risk of post transaction restructuring in connection with potential future disposals, which could undermine the remaining value of the covenant
    • Reduced visibility of the covenant as the sponsor would become a subsidiary within a larger group.
What action did we take?
  • Having undertaken the “defence planning”, the Trustees and advisers were ready to engage quickly with the key stakeholders
  • We advised the Trustees on how to ensure that the Scheme’s concerns were high on the bidder’s agenda, through meetings and written communication
    • As part of this, the Trustees were able to effectively engage with the Pensions Regulator and use a coordinated PR campaign to increase public awareness of the pension scheme issues
  • As a result, the Trustees made their concerns clear to the key stakeholders and were able to negotiate a mitigation package through robust and consistent messaging
    • The covenant package included a replacement topco guarantee, a tighter funding basis and disposal triggers to address concerns around further covenant leakages
    • This represented an improvement in the Scheme’s overall covenant package and gave the bidder greater certainty regarding the cash funding requirements for the Scheme going forward
What are the key takeaways?
  • Your scheme’s covenant could be rapidly undermined by the impact of a corporate transaction
  • Trustees and sponsors should seek to understand in advance those scenarios where access to value can change and what mitigation could be required for each scenario
  • An effective method for approaching corporate events includes our ACE framework, which incorporates the following:
    • Anticipation of corporate events to highlight potential asks and strategies which can be implemented quickly in stressed scenarios
    • Communication in a clear and quick way with key stakeholders to ensure that the scheme’s concerns are taken seriously and to allow the scheme and sponsor to find a win-win solution
    • Execution effectiveness through preparation and appropriate governance to help trustees negotiate with the sponsor within often stressed time constraints, such as the takeover timetable
Notes/Sources

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Last update: 27 May 2021

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