I have long maintained that any individual or organization that invests in a company needs to check under the employee benefits hood before allocating money initially, and regularly thereafter. I can give you countless examples where incomplete due diligence led to an overly rich acquisition or investment that resulted in a new owner having to deploy cash to write checks to retirees and/or incur the costs of restructuring an otherwise untenable situation.
Failure to carry out a comprehensive ERISA-focused due diligence of a target portfolio company is not good for numerous reasons. Having done economic analyses of companies with underfunded pension plans, I know firsthand that it is often a rude awakening for investors such as private equity funds when they are confronted with the reality that what they want and what they end up with in terms of buying forecasted growth are not always the same. Reasons to worry include, but are not limited to, the following:
- A private equity fund may not be able to realize its target rate of return because a portfolio company cannot sufficiently grow without cash that is now redirected to support employee benefit plans.
- A pension plan that has invested in said private equity fund will be none too happy if performance falls short of expectations, especially for something that arguably should have (and could have) been considered and addressed as part of the original deal.
- An unhappy pension fund investor may turn around and sue a private equity fund for alleged failure to have properly researched "what if" situations, taken on "too much" risk and disclosed too little information. Litigation in turn can be an expensive proposition for a private equity fund, making it even more difficult to achieve even minimum hurdle rates.
The issue of private equity ownership and portfolio company pension liabilities was heavily discussed as the result of a 2007 Appeals Board of the Pension Benefit Guaranty Corporation ("PBGC") decision about ownership, control and responsibilities for portfolio company pension plan gaps. In "Private Equity Funds: Part of the ERISA Controlled Group?" (December 19, 2007), O'Melveny & Myers LLP attorneys Wayne Jacobsen and Jeff Walbridge explained that "[i]f the PBGC's position endures, it could have significant ramifications for private equity fund investments in portfolio companies that sponsor defined benefit pension plans...[t]he fund could be required to use any or all of its assets, including the ownership interests of the fund in any or all of its portfolio companies, to fund the pension obligations of the bankrupt portfolio company."
Imagine the happy faces in private equity land when the U.S. District Court of Massachusetts opined on October 18, 2012 in favor of Sun Capital Partners III, LP and related parties. According to "Potential ERISA Title IV Liabilities of Private Equity Firms - Eliminated by the Sun Capital Decision?" (November 2012), Edwards Wildman attorney Mina Amir-Mokri describes the decision as a "significant victory for private equity firms" but explains that Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund was to be appealed.
On July 24, 2013, the U.S. Court of Appeals for the First Circuit reversed the earlier decision and put private equity funds in a potential liability position once again. According to "Private Equity Funds Further Exposed to Portfolio Company Pension Plan Liabilities" (July 29, 2013) Latham & Watkins attorneys Jed Brickner and Austin Ozawa offer post-opinion practical hints such as the need for private equity firms to "carefully consider how to structure their funds and acquisition structures to avoid characterization as a trade or business and avoid inclusion in the same controlled group as their portfolio companies." Additionally, they urge private equity funds to pay attention to the "structure of their funds' investments"...possibly "dividing their investment between two or more of independently managed funds with distinct portfolios to support a finding that no individual fund (or group of 'parallel' funds) controls any portfolio company (and no set of funds is treated as a joint venture). Paul Hastings attorneys Stephen H. Harris, Eric R. Keller, Ethan Lipsig and Mark Poerio assert that private equity funds would do well to own "less than 80% of a portfolio company"...perhaps via "thoughtful adjustments to ownership structures and management operations" that can help to reduce the exposure to portfolio company pension liabilities. See "Private Equity ERISA Alert: Consider ERISA Pension Liability Risks from Portfolio Plans" (July 2013).
While legal experts weigh in on the important issue of what responsibilities belong to private equity funds, if any, to portfolio company ERISA plan participants, institutional investors such as pensions, endowments, foundations and family offices - and their investment consultants and advisors - should take heed. If a private equity fund's exposure to a portfolio company with a problem pension plan ends up shrinking the wallets of institutional investors, serious questions will understandably be asked about who should have done what and when.