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The Actuary The magazine of the Institute & Faculty of Actuaries
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Monitoring employer covenants

Economies move in cycles. The UK economy had enjoyed uninterrupted growth since the last recession in the early 1990s, due in part to the government’s desire to manage the economy away from the earlier ‘boom and bust’ post-war cycle. As the UK now technically enters a recession, having experienced two consecutive quarters of negative GDP growth, clearly there will be repercussions for sponsoring defined benefit schemes and the covenant they provide to their pension trustees.

Trading environment
Long-established businesses will have survived recessions in the 1970s, 1980s and 1990s. Nevertheless, the current, rather severe, downturn has already claimed such well-known names as Woolworths and MFI and, to some degree all businesses now face a number of challenges such as more difficult trading conditions; reduced revenues or rate of growth of revenues; slower payments from customers or even defaults on payment; delay to capital investment for future growth generation; greater difficulty in refinancing; higher cost of borrowing; and knock-on effects of any credit rating downgrade.

The extent to which a company is affected will depend on, among other things, the industry in which it operates, its debt profile and its exposure to financial markets. Understanding what businesses go through during a recession can help distinguish those employers that are likely to survive and those that could run into difficulty.

Cash is king
What ultimately breaks a company is running out of cash. Creditors need to be paid in cash, particularly a company’s lenders and suppliers, without which it cannot function. A company’s cash supply essentially derives from cash flow generated by its operations, cash on its balance sheet, headroom under its debt facilities or cash raised from shareholders.

Generating cash
The ability of a business to generate cash is an important measure of its financial strength and a central component of a covenant review. Cash flow is not the same as profit, although it is related. Profit is a somewhat notional gain in an accounting period arising from net income generated (sales less costs) or from a booked increase in asset values, irrespective of whether a cash payment has been received. For example, an increase in amounts owed to a company or in the value of its inventories might register in the profit and loss account as a profit, but it is not necessarily cash in hand. These amounts would be expected to convert to cash at some point in the future, but this might not be soon enough for creditors who have their own cash flow needs.

Supporting cash flow are sales, and the first sign of tougher trading conditions is likely to be a reduction in ‘top line’ sales — consumers tighten their spending and companies rein in budgets, so demand for goods and services falls. Some sectors are clearly affected more than others. Food retail, energy and healthcare industries tend to be resilient during economic downturns, whereas expenditure on cars, consumer goods and construction is less essential. However, a reduction in sales is not in itself a sign that a company is in difficulty, particularly given that in a recession, demand is largely beyond companies’ control. What is more relevant is the effectiveness of a company’s response.

Companies’ first line of defence is to reduce costs. From heavy industry to professional services, companies have been shedding staff to cut costs. Companies will also attempt to free up cash by reducing their short-term cash requirement, or ‘working capital’, by minimising stock levels and amounts owed to them by their customers, while delaying payments as far as possible to creditors. This is not easy, particularly when all companies will have the same objectives. The companies most likely to be successful are the large industry leaders able to squeeze payment terms with suppliers who cannot afford to turn down the business. Changes in a company’s working capital requirement provide a useful indicator of future cash flow problems. Furniture retailer Land of Leather had no debt but went into administration last month after running out of working capital.

Managing debt
When times are good, companies use their borrowing facilities to expand the business, which makes sense provided the return outweighs the interest on the amount borrowed. When times are bad, debt facilities are more likely to be used to provide additional liquidity, for example to pay suppliers where insufficient cash has been generated by the business. Recessions see debt levels increase as businesses borrow to meet their cash requirements and make payments to shareholders, which in turn increases interest costs. The ability of a company to meet its ongoing debt payments is therefore something trustees need to monitor closely, and again forms an integral part of a covenant review.

In an ordinary trading environment, companies do not need to worry about paying off their debt because they can simply take out new facilities to pay off the existing ones when they expire. Indeed, such facilities can be very large relative to the company and would be extremely difficult to pay off from other assets. The lack of availability of new credit, however, clearly interrupts this cycle, and if companies cannot refinance their debt, the results can be literally terminal.

The need to refinance can be either scheduled, due to the known expiry of existing facilities, or unscheduled, due to the actual or impending breach of borrowing terms (debt covenants). Even if a company is able to refinance, interest currently charged by lenders is at a high level due to wariness around credit risk in a recession, creating a greater strain on cash flows. Knowledge of the expiry dates of the debt and the covenants under the facilities will clearly provide a valuable insight into a company’s shortterm refinancing needs. However, availability of information can be a problem. Publicly listed companies often provide this information to investors, while others may be reluctant to disclose the details.

And then there are the shareholders...
Company directors are accountable to shareholders, who expect a return on their investment. Existing and potential shareholders are also a source of new capital if needed. The pressure to reward shareholders through dividends or share buy-backs is considerable, even when not wholly justified by a company’s performance. If directors opt to reward shareholders where insufficient cash has been generated, to cover the cost, a company will need to deplete its cash reserves or borrow more. As cash leaving the business, this could be a serious concern for trustees.

The trustee response to a weakening covenant
Covenant assessment should be forward-looking and, as far as possible, look through the economic cycle. If trustees can satisfy themselves that the employer is still going to be around after the current period of belt-tightening, then they might pull back contribution demands until the company finds conditions easier. This is the line the Pensions Regulator seems to be taking, but the risks of deferring contributions are obvious.

If trustees have concerns about the strength of the covenant in the longer term, bearing in mind that even apparently very strong businesses can deteriorate rapidly in a deep recession, then simply asking for much higher cash contributions might precipitate the sponsor getting into difficulty. Solutions need to be more creative, and there is a wide range of measures that can be deployed to provide security for the trustees’ funding requirement in the absence of hard cash. Trustees are well advised to seek professional corporate finance advice in order to negotiate the best outcome.

Paul Thornton OBE leads the Pensions Advisory team at Gazelle
Richard Hall is a director within the Pensions Advisory team at Gazelle