Adopting a "half glass full" attitude, my co-author and I wrote about the business opportunities for private equity fund general partners ("GPs") with portfolio company problems. In "GPs Eye New Ruling" (Mergers & Acquisitions, December 2013 Issue) by ERISA attorney David Levine and Accredited Investment Fiduciary Analyst, Dr. Susan Mangiero, we talk about the aftermath of a recent legal decision that has the private equity world on high alert.
By way of background, in Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund, the United States Court of Appeals for the First Circuit ruled that a private equity fund can be held liable for the pension obligations of a portfolio company. If left unchecked, private equity funds (and their limited partners such as pension plan investors) could see a diminution of performance for any number of reasons. For one thing, a GP may be unable to exit a position within a reasonable period of time if potential buyers get scared of being saddled with an expensive, underfunded retirement plan. In addition, cash that was otherwise earmarked to finance new growth projects may be used instead to comply with statutory contribution rules. Indeed, I have carried out financial analyses for prospective buyers on the basis of how much "extra" a pension problem is likely to cost.
While the downside possibilities are real, Attorney Levine and I point out that "lessons learned" from the Sun Capital decision enable a GP to take action preemptively as a way to potentially "maximize value from portfolio companies while also mitigating future risk." Savvy asset managers can adapt their due diligence process to help avoid any issues that could preclude an exit within the typical three to seven year time period from an initial funding round. Some of the many steps that a GP can take include, but are not limited, to the following:
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
For further reading about this important legal decision and the economic and compliance imperatives, you can read earlier blog posts and link to various law firm memos on this topic. See "Pension Liability Price Tag For Private Equity Funds and Their Investors". Also see "More About Private Equity Funds and Pension IOUs."