GPs Eye New Ruling

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The Sun Cap decision paints the image of a bright line between PE funds that have a good chance of realizing an exit strategy and those that will bear the cost of an expensive pension plan

The U.S. Court of Appeals for the First Circuit recently ruled that a private equity fund can be held liable for the pension obligations of a portfolio company in its decision in Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund.

Although this ruling focuses only on who might be responsible for the liabilities of underfunded pension plans, it should be looked to as a potential opportunity to maximize value from portfolio companies while also mitigating future risk.  Given the magnitude of retirement liabilities in the U.S. and continued headlines about retirement plan problems, general partners may find themselves under intense scrutiny for their involvement, with potential liability for the employee benefit plans of their portfolio companies.

Reasons to Be Concerned

As described by the Private Equity Growth Capital Council, the business model for a typical private equity fund relies on an exit of three to seven years from an initial investment. When a portfolio company has a problem that will be expensive to fix, it makes it difficult for the private equity fund owner to sell one portfolio company and realize any gains. Whether seeking to take a business to the market for the first time via an initial public offering (IPO) or selling a portfolio to a competitor, a private equity fund owner must demonstrate that certain financial thresholds have been met. The Sun Capital decision paints a potential bright line between private equity funds that have a good chance of realizing their exit strategy and those that will bear the cost of an expensive, underfunded pension plan.

In addition, there is increased regulatory, compliance and due diligence sensitivity about how corporate retirement plans are being handled by ERISA fiduciaries. It is no surprise that allegations of breach are popping up in courts with more frequency. In some cases, the damages are in the millions of dollars. This means that general partners are exposed to potentially huge legal risks when they fail to properly take potential retirement plan liabilities into account when deciding to invest in a firm for the first time or add to an existing allocation. Private equity general partners, funds of funds and advisers stand to lose in yet another way as the result of the Sun Capital Partners decision. If one or more companies in a private equity fund portfolio are burdened with an underfunded defined benefit plan, federal regulation mandates that cash must be infused to correct a deficiency. This drag on earnings will make for an uncomfortable discussion with limited partners (LPs), all of whom will want to understand why performance is so bad and whether they are obliged to meet capital calls. This in turn could exacerbate difficulties for private equity funds in need of liquidity. For intermediaries, their revenue will be diminished if LPs look elsewhere.

Pre-Emptive Action Can Save Money and
Maximize Investment Value

Steps a private equity fund should consider include the following:

1. To the extent that a private equity fund is relying on the position that it is not a “trade of business” and is therefore not subject to liability for a portfolio company’s pension underfunding, it is wise to review the potential economic, fiduciary and legal risks should this position be challenged in court.

2. Review its holdings that are at least 80 percent owned by the private equity fund. Total equity exposure should include common stock, preferred stock and possibly economic rights associated with warrants and/or equity derivatives such as swaps. Although a core focus of any such review should be with respect to holdings subject to jurisdiction in the First Circuit (Maine, Massachusetts, New Hampshire, Puerto Rico, and Rhode Island), a broader review of holdings elsewhere might also be considered.