Benefits due diligence in mergers and acquisitions

In most acquisitions the employee benefit plans receive a day or two of attention from a generalist, a request for the Form 5500s and a representation in the purchase agreement that the plans are in compliance. The buyer then discovers, after closing, a pension deficit measured on the wrong basis, a retiree medical promise nobody priced, a withdrawal liability exposure that follows the controlled group or a 401(k) with a compliance failure that costs more to correct than the plan is worth. Benefits diligence exists to find those before the price is set.

What the buyer inherits

In a stock purchase, the buyer acquires the target with all of its plans and all of their liabilities, known and unknown, including those of plans that were terminated years earlier if the termination was not done correctly. In an asset purchase, the buyer chooses which plans to assume, but successor liability doctrines, controlled group rules and collective bargaining obligations can attach liabilities the buyer did not intend to take, and a Section 4204 sale of assets involving a multiemployer plan has its own requirements.

The exposures that most often change a price:

• Defined benefit pension underfunding, measured on a termination or annuity purchase basis rather than the accounting basis in the financial statements, because the buyer's cost is what the benefits will actually cost to settle or run off. Minimum funding requirements over the next several years and PBGC premiums belong in the cash model.
• Retiree medical. Many employers believe the promise is unfunded and modest. The liability is often neither, and the plan document may or may not give the employer the right to amend or terminate it. Reading that document is the first step; valuing the promise is the second.
• Multiemployer plans. Withdrawal liability can be triggered by the transaction itself, by post-closing integration or by a later restructuring. The estimate the target is entitled to request from each plan should be in the data room. If it is not, that is a finding.
• Nonqualified deferred compensation and executive agreements. Change in control triggers for vesting and payment, rabbi trust funding requirements, Section 409A compliance and Section 280G excess parachute payments, which can carry an excise tax for the executive and a lost deduction for the company.
• Qualified plan compliance. Late deposit of 401(k) deferrals, failed nondiscrimination tests that were never corrected, missed required amendments, uncashed check populations and plan documents that do not match operations. The IRS and Department of Labor correction programs can fix most of these, at a cost that should be known before closing.
• Controlled group consequences. After closing, the target's plans and the buyer's plans are tested together for coverage and nondiscrimination once the transition period ends. A plan that passed on its own may fail in the combined group.

Valuing the pension

The buyer's accountants will restate the acquired pension under ASC 805 at fair value on the closing date, which eliminates the target's accumulated unrecognized gains and losses and resets the obligation on the buyer's assumptions. That changes the pension expense the buyer will report, and it changes the EBITDA bridge: the service cost and the other components of net periodic cost land in different lines and may be treated differently in the deal model.

For pricing purposes, the more useful measurement is cash. What will the plan require in contributions over the holding period under the funding rules, what would it cost to terminate or to transfer to an insurer and what is the range of outcomes under interest rate and asset return scenarios? A plan that is 95 percent funded on the accounting basis can be 80 percent funded on a termination basis, and that difference is the buyer's money.

Structuring around what is found

Diligence findings become deal terms. Specific indemnities for identified exposures, purchase price adjustments, escrows sized to the correction cost, pre-closing actions such as terminating a defective 401(k) before it merges into the buyer's plan, Section 414(l) requirements for merging or spinning off plans, PBGC reportable event filings when the contributing sponsor changes and transition services for plans the seller keeps all follow from a clear statement of what the buyer is taking on and what it is worth.

What a diligence review produces

A useful review is short, quantified and specific. It identifies each plan and arrangement, states the exposure in dollars or in a range, flags the ones that affect price and separates them from the ones that are housekeeping, and recommends how each should be handled in the agreement. It is written for the deal team and counsel, who need conclusions, with the actuarial detail in an appendix for the accountants who need the support.

Our approach

The firm's principal has led more than 300 benefits diligence reviews for private equity firms and strategic buyers in the United States and internationally. We work from the data room and a targeted request list, deliver findings in the deal's timeframe and remain available through negotiation and post-closing integration, including the plan mergers, spin-offs and filings that follow.

This article is general information about the topics discussed and is not actuarial, legal or tax advice for any specific plan or employer.