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.
3. Review underfunded pension plans before and after each acquisition of a portfolio company in order to develop strategies for addressing the Pension Benefit Guaranty Corporation’s aggressive litigation positions that it has been taking lately. Failure to do so could result in unnecessary delays in connection with corporation transactions, including the sale of portfolio companies. Examine the collective bargaining agreements for any or all portfolio companies. Although the Sun Capital Partners case was about liability for pension funding obligations under a multiemployer pension plan (i.e., a pension plan maintained independent of an employer pursuant to collective bargaining), there is some concern that the logic of Sun Capital Partners might be extended to conclude that a private equity fund is conducting a “trade of business” under the Internal Revenue Code through its management and oversight of portfolio companies. A decision concluding that a fund is a trade or business for Internal Revenue Code purposes could impact a fund’s representations of its attempts to minimize its unrelated business income tax liability and/or its acceptance, pursuant to the Internal Revenue Code, as a trade or business.
4. Assess the economic, fiduciary and legal attractiveness of all employee benefit plans that are offered by private equity portfolio companies. This includes traditional defined benefit pension plan, 401(k) plans, and health and welfare arrangement. Individually and collectively, ERISA plans can carry significant liabilities that have the potential to (a) materially reduce overall business profitability (b) increase insurance premiums (c) lead to expensive litigation and/or regulatory enforcement (d) impede liquidity and (e) hamper capital raising. As a result, a general partner may never be able to realize the growth targets that motivated a particular investment in the first place. Just as significant, a private equity fund may find itself limited in its ability to exit a particular investment.
5. Meet with retirement-focused advisers, actuaries and counsel before investing in a new portfolio company. The due diligence analysis should be comprehensive. This means that a private equity fund will want to assess both the current and projected pension plan liabilities for a portfolio company as well as the riskiness of its investments in its pension and 401(k) plan. If a pension plan’s assets are illiquid or overly conservative, a deficit may occur or grow bigger. It is likewise important to understand whether the assumptions underlying actuarial calculations are overly optimistic. The objective is to understand the seriousness of a given situation in terms of economic, fiduciary and legal vulnerability.
6. Assess the accounting impact for any and all retirement plans. Be prepared to explain performance volatility to LPs as the result of an ERISA problem.
7. As the family of “de-risking” products continues to expand, consider restructuring a portfolio company’s ERISA plan if, by doing so, a private equity fund owner can improve the likelihood of an exit within its target time horizon. However, because ERISA’s fiduciary rules impose a duty of loyalty to participants and beneficiaries, decisions on de-risking should be evaluated under these standards.
8. Determine, in conjunction with ERISA counsel, whether to engage an “independent fiduciary” for purposes of evaluating an array of possible restructuring solutions. Buying annuities to settle pension liabilities or investing in employer securities or other “hard to value” assets are examples.
9. Recognize that the Sun Capital Partners decision could encourage further litigation and regulatory activities. Private equity funds might be well served to consider whether minor tweaks to their structure merit use, including the creation of additional services entities that are commonly used in operating company structures. Clarification of offering documents, careful monitoring of activities and/or comprehensive documentation of its involvement with portfolio companies can go a long way to help insulate a private equity fund from a finding that it is engaged in an Internal Revenue Code trade or business.
While this list of steps is long, it need not be overwhelming. Working with experienced financial advisers, as well as knowledgeable ERISA counsel, is a recommended way to efficiently address the future ramifications of Sun Capital Partners and to maximize the value of investments in portfolio companies.