Wednesday, 25 April 2018

    Trustee Briefing: Employer Covenant

    How can trustees effectively maintain their employer covenant?

    What happened?

    Continued fragile economic conditions have led to a further series of high profile insolvencies, both in the UK and overseas. Credit markets remain difficult and the ability of corporates to access debt finance remains variable.

    Examples of well-established brands encountering recent difficulties include Kodak and Peacocks.

    Both of these businesses are over 100 years old – showing that nothing can be taken for granted with even the most well-established companies. 

    What does this mean for trustees?

    Now more than ever, trustees need to be taking a very careful and regular look at the covenant of their schemes’ sponsoring employers.  How often they review the covenant will depend on the employers’ circumstances and risk profiles.

    For a number of years, The Pensions Regulator has emphasised the importance of monitoring the employer covenant.  Their guidance in November 2010 entitled “Monitoring employer support” includes the following text in the introductory paragraphs:

    “All trustees should therefore have a framework for assessing and reviewing employer covenant, including regular monitoring. Trustees should regard this as just as important to the security of the scheme as monitoring fund performance. Our research indicates that some schemes already have a sound approach; for others, improvement is necessary.”

    As well as reviewing traditional financial metrics such as historic profitability and balance sheet strength, recent high profile insolvencies illustrate just how crucial it is to focus on both the “here and now” and future prospects. 

    Understanding the business dynamics of the employer, and its financial strength and performance, are clearly important. 

    But issues that could really catch out a sponsoring employer (and pension scheme trustees) in the current environment are their market or technology moving against them; running out of cash; or finding themselves in breach of covenant with their lenders. 

    You have to look forward in assessing the covenant, and where things are looking tough, make sure you act early to protect the scheme’s position.

    There is, of course, a tension between pushing too hard to recover cash for a scheme and precipitating an insolvency.  Clearly, you need to be careful not to create the outcome you are seeking to avoid.  There are a number of ways in which the covenant to a scheme can be enhanced whilst helping the employer thrive. 

    Having a constructive approach to the covenant can be mutually beneficial for both employer and pension scheme.

    What next?  Action points

    Current tough market conditions have made it crystal clear how important it is for trustees to really understand their sponsoring employers’ position and prospects – and be ready to act quickly if things appear to be moving against them.

    There are five key questions trustees should regularly ask themselves about the sponsoring employer’s covenant:

    1.    Do I really understand the market in which the employer operates – including how the market is moving; competitive dynamics; and the relationships with key customers?

    2.    Do I really understand the employer’s cash position and cash forecasts – as well as its accounting profitability and balance sheet strength?

    3.    Do I really understand the position of third party stakeholders such as lenders – and the balance of power and potential outcomes if the company gets into difficulty? 

    4.    Is a refinancing due in the short or medium term?  Many companies who enjoyed access to debt funding 6 or 7 years ago may not find it so easy to refinance now.

    5.    Have we done all we reasonably can to protect the scheme as (often) a major creditor to the company?

    If the answer to these questions is “yes”, have a gold star!

    But if in doubt, shout!  Don’t be afraid to get thorough professional advice.  The costs of such advice may pale into insignificance compared to the value which may be gained by improving understanding of the covenant; and acting early and effectively to protect the scheme’s interests.

    Paul Brice is head of corporate finance and restructuring within the trustee services business at RPMI, the pensions administrator. He leads an in-house team providing employer covenant and related corporate finance advice for the Trustee of the Railways Pension Scheme.


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