Last week a US Court of Appeals did the unthinkable and labeled a private equity fund a trade or business. The court decided that a Sun Capital fund was not “not merely a ‘passive’ investor”, but actively involved in the management of its portfolio company Scott Brass, a metals manufacturer that went bankrupt in 2008.
The court described Sun’s ownership stakes in Scott Brass as “investment-plus”, meaning its hands-on investment approach was interpreted to be a type of business operation.
Definitions matter. If deemed a trade or business under the Employee Retirement Income Security Act (ERISA), a private equity fund could be responsible for funding a portfolio company’s insolvent pension plan. The court said its investment-plus test was “very fact specific”, which took into account a number of factors, including GP-appointed board members and marketing literature, cautioning that no one factor alone decided its decision.
Consequently GPs, especially those touting their value-add and operational skills, will understandably be spending more time evaluating the risk of unfunded pension liability for potential deals. Here are five factors that may lead a judge to believe your fund is a trade or business for ERISA purposes.
1. Super board member
GPs often appoint one or more of their own to sit on a portfolio company’s board of directors for oversight and management purposes. Private equity lawyers don’t seem to believe this in and of itself would trigger the trade or business label, but a GP-appointed board member who is first among equals is another matter. Ideally, board meeting minutes and records should show the GP representative acting in unison with other directors, and not performing any duties (such as an employee search or an executive decision) independently from the board that could be attributed to the fund itself, advises Pepper Hamilton employee benefits lawyer Michael Crumbock.
2. Decisions, decisions
Private investment funds that have the right to hire, terminate, and influence the compensation of portfolio company employees are at greater risk of being labeled investment-plus vehicles. Even “frequent meetings with senior staff” to discuss business plans or personnel were factors weighed in the Sun Capital case. The court also said Sun Capital “acted as a middle man” when hiring outside consultancies for the portfolio company. In other words, it would appear key decisions need to originate from within the portfolio company (and not mandated by the GP).
3. Deal fees
The court said deal or monitoring fees charged to Scott Brass was another consideration in its decision. A passive investor would not receive such a direct economic benefit, the judge reasoned. Missing from court papers was any mention of whether or not Sun Capital offset its deal fees 100 percent against management fees (Sun Capital declined comment). Though admittedly speculative, a GP that offers its investors a 100 percent deal offset may be able to convince a judge to disregard this particular factor when determining ERISA liability.
4. Marketing your PE strategy
In determining if Sun Capital was more than just a passive investor, the court noted that the firm described itself as being “actively involved in the management and operation of the companies in which they invest.” The court also pointed to Sun Capital fund agreements which said the “principal purpose” of the partnership is the “management and supervision” of its investments. At a time when more GPs than not like to advertise their value-add capabilities, it may be up to lawyers and communications specialists to create careful language that can market a GP’s operational capabilities without triggering ERISA concerns.
5. Having a game plan
Entering into an investment with the express aim of replacing management or introducing operational changes may raise red flags for ERISA. According to court records, Sun Capital’s private placement memorandum said the firm intended to introduce “significant changes” within the first three to six months of owning a company – an investment strategy the judge interpreted as being above and beyond the role of passive investor.
It’s fair to say most private equity firms will find they fall into one if not more of the categories above, which led to Sun Capital funds being deemed a trade or business. For that reason, what happens next with the case will be of great importance; no costs have been awarded yet, as a district court must now answer certain technical questions left unresolved by the appeals court. Watch this space.
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