When you see a GP eagerly offer a co-investment opportunity, two things probably spring to mind as to why: the fund manager is either looking to increase his capital firepower, or satisfying the interests of the fund’s investor base (or three, some combination of both). But private equity lawyers speaking with Private Equity International's sister publication PE Manager have recently begun raising a less known strategy in co-investment deals – they may just be a way for GPs to shield a fund from a bankrupt portfolio company's pension plan obligations.
For the uninitiated, GPs found some guidance on the issue in October when a US district court ruled that three funds sponsored by Sun Capital, which collectively held a controlling interest in a bankrupt portfolio company, were not responsible for its unfunded pension liabilities.
In court, the decision rested on whether or not buyout funds represent a “trade or business” under Title IV of the Employee Retirement Income Security Act (ERISA). If so, and assuming the fund controlled at least 80 percent of the company, a GP could be liable for its unfunded pension liabilities. Sun Capital however was able to successfully convince the court a fund (which has no employees and is only a pool of capital made for passive investments) is not a “trade or business”.
In a separate argument Sun Capital was also accused of splitting its investment between multiple funds to evade the 80 percent threshold test (the funds together owned 100 percent of the portfolio company). Sun Capital acknowledged ERISA liability concerns in its decision to split the investment across funds, but convinced the court that other factors come into play when doing so (for example risk diversification).
The Sun Capital decision however is being appealed, and there is no guarantee a higher court will reach a similar opinion on the matter, leading some lawyers to advise their GP clients to consider other means of staying below the 80 percent ERISA “common control group liability” benchmark. That’s how co-investments, either with other firms or a select few LPs, can be a shield from pension liabilities.
The court decision has shown that courts can be receptive to the argument that splitting an investment across multiple funds or partners is a legitimate way of spreading risk
Ira Bogner, a partner at law firm Proskauer, summarised the strategy succinctly in a recent conversation with PEM: “You could give a limited number of investors the ability to take a slice of the investment to get you under the 80 percent, and this means you don’t have the same investor base, and you have the same argument that those entities shouldn't be aggregated [under common control] as well.”
To be clear, lawyers are not advising GPs to begin offering co-investment opportunities to investors or peer firms with the express intent of evading ERISA liability; such a strategy likely wouldn't fly in court. However, the Sun Capital decision has shown that courts can be receptive to the argument that splitting an investment across multiple funds or partners is a legitimate way of spreading risk. That opens the door for co-investments (a legitimate risk diversification strategy) to double as a shield against pension liabilities when enough side-investors dip the fund below an 80 percent stake in any given portfolio company.
Looking ahead, it’s safe to expect the strategy to trigger a debate on GPs’ moral obligations to employees of failed portfolio companies, a story PE Manager would be sure to cover if it develops. GPs are not keen to tie the pension obligations of one portfolio company to another in the fund; pensioners, however, will take small comfort in fund managers’ fiduciary duties when years of retirement savings are unfortunately put into jeopardy.