Pension black holes cast shadow

PERMIRA'S faltering bid for WH Smith - due to the retailer's £215m pensions black hole - has cast a shadow over UK mergers and acquisition. Indeed, it could signal a pivotal point in the relationship between venture capitalists and the UK retail sector.

If approved, the Pensions Bill currently being debated in Parliament, is likely to deter some investors or, at least result in considerably lower bid prices.

The sector has recently been a happy hunting ground for private equity firms, but big players could be particularly exposed under new legislation.

WH Smith is perhaps an extreme example. The shortfall is unusually large - up to a quarter of the company's stock market value.

Pension trustees have also been able to take up a hard-bargaining position, demanding Permira plug part of the hole with a lump sum, in stark contrast to the existing management's plan to amortise the deficit over 12 years.

But this is not an isolated case - funding its pensions gap is one of Philip Green's key concerns in his quest for M&S.

And rumoured private-equity target MFI has recently uncovered an additional £40m shortfall. Although unlikely to be a deal breaker, it will probably lead to discounted bids by potential buyers.

Central to their concerns is the Pensions Bill and measures aimed at preventing firms from using 'financial engineering' to walk away from pension obligations. The Government has proposed that these measures be backdated to June 2003.

The Bill would also give the new pensions regulator more power to pursue affiliated firms, the holding company or even the directors to settle a pension debt.

It is this contentious point which would overexpose venture capitalists - they fear unrelated firms in a portfolio could be liable for another company's pension debts.

Indeed, the British Venture Capital Association says such rules would discourage investment and 'could have a disastrous impact on the UK's private equity industry in particular'.

Its concerns should not be overlooked - private equity is a major force in UK retail. Attracted by the sector's ability to generate cash, venture capitalists have invested heavily in the sector in the past five years.

In the department stores sector alone, they account for more than 50% of market share. According to mergermarket, the M&A intelligence company, private equity firms invested £866m in the UK retail sector in 2001, £3.46bbn in 2002 and £5.25bn in 2003. It is also clear such deals are no longer restricted to the middle tier.

The successful £1.7bn bid by consortium Baroness Retail for Debenhams in October 2003 raised the bar, only to be trumped by Green's audacious £8.3bn tilt at M&S.

Putting aside the pensions threat, the impressive rates of growth are likely to continue in 2004, with deals getting bigger as the consortium approach takes hold.

So it is clear future big deals could be at stake if the Pensions Bill is passed. Some commentators would disagree, suggesting the level of such deficits has been exaggerated.

But, in reality, up to 95% of companies' funds are in arrears and many such funds remain exposed to the vagaries of the market.

So WH Smith could set a precedent. It may be the only big deal to be hit by the impending regulations, but others will follow if the Bill remains in its present form.

Tim Sleep is head of retail at accountants Ernst & Young