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Private equity could be considered a trade or business

A court ruling against Sun Capital Partners doesn’t just revive the possibility that private equity could be on the hook for pension liabilities, it could undermine the entire model.Thomas Duffell and Nicholas Donato report.

Private equity firms may be more likely to find themselves on the hook for a bankrupt portfolio company’s unfunded pension plan under Employee Retirement Income Security Act (ERISA) rules, following a US federal appeals court decision in June.

It all stems from an ongoing dispute between the New England Teamsters & Trucking Industry Pension Fund and private equity firm Sun Capital Partners over pension liabilities at manufacturer Scott Brass, a portfolio company of Sun’s that went bust. 

The case hinged on whether a private equity fund can be considered a ‘trade or business’, or whether it is merely a passive investment vehicle. Previous court rulings have taken the latter view – but the latest ruling from the appeals court puts it in the first category, which would make it liable for the company’s outstanding pension obligations.
Mike Crumbock, an employee benefits attorney at Pepper Hamilton, told Private Equity International the latest ruling was “discomforting” for private equity. “Going forward, I don’t think private equity can avoid pension liabilities by relying on not being a trade or business … Funds are going to have to be very careful about what control they exercise over their portfolio companies and how they structure their investments.”

(Another worry is that if funds are considered to be a trade or business, they could lose their ‘pass-through’ tax status – meaning that non-US investors could become subject to US tax on income and gains from private equity funds. It also strengthens the argument for treating carried interest as ordinary income rather than capital gains for tax purposes. However, the court did try to obviate some of these concerns by stressing that its decision was limited purely to ERISA.) 

Crumbock: cautions 
funds to be careful with
structuring investments

Significantly, the court said it made this latest ruling precisely because Sun was so actively involved in the company’s operations (including, for example, hiring and firing personnel). It described Sun’s ownership of Scott Brass as “investment-plus”, i.e. its hands-on approach was interpreted to be a type of business operation. So the whole idea of active ownership – which most GPs now either claim or aspire to – suddenly becomes an Achilles heel, at least as far as ERISA is concerned. 

If this ruling survives (Sun is appealing), there are a few things that GPs – particularly those with a hands-on approach – will have to be wary of if they want to avoid being tarred with the same brush.
For instance, if the GP sits on the board and has some kind of special powers or prominence over the other directors, that will be frowned upon. Taking key decisions on behalf of the portfolio company may also cause problems (the court referred to Sun’s role in hiring external consultants, for instance). Charging deal or monitoring fees (unless there’s a 100 percent offset) may count against a manager. Aggressively marketing the firm’s operational capabilities could have a similar effect. And going into an investment with a plan to make sweeping operational changes (which will often be the case, particularly in Sun’s segment of the market) also reduces a GP’s chances of being considered a ‘passive investor’.

Of course, the downside of this ruling is that it would almost certainly makes this bit of the market less attractive to firms like Sun – meaning that there’d be fewer rescue options for struggling companies. Is that really what the courts want?