Structuring Private Equity Deals in 2017: Considerations for Buyers While They Wait for the Sun Capital Appeals to Play Out
Sun Capital Partners III, LP v. New England Teamsters and Trucking Industry Pension Fund has been analyzed extensively over the past four years, as it has made its way from the US District Court for the District of Massachusetts to the First Circuit Court of Appeals and back again. With the case once again on appeal, we must wait to see how the latest court decision will further influence the structure of private equity deals. In the meantime, private equity funds should use the most recent District Court and First Circuit Sun Capital decisions as a road map for structuring deals where the target portfolio company has defined benefit pension plan or multiemployer pension plan liabilities.
Recap of the Facts
If you work in the private equity space, you may be familiar with the main aspects of the case: Sun Fund IV owned 70 percent of Scott Brass Inc. (SBI), and Sun Fund III owned the remaining 30 percent. The Funds were each owned by a general partner. The general partners shared the same limited partnership committee, which was made up of two individuals who were also the Funds’ advisors. This article will refer to Sun Fund III and Sun Fund IV collectively as the Funds.
Under the Multiemployer Pension Plan Amendments Act of 1980 (the MPPAA), two employers will be treated as a single employer if they are trades or businesses under common control. If the employers are treated as a single employer, they can be held liable for each other’s defined benefit pension plan obligations. The prevailing view was that private equity funds’ investments in portfolio companies were not a “trade or business”—such investments were simply passive investments. Even if private equity funds investments in portfolio companies were considered a “trade or business,” a fund would have to own at least 80 percent of a portfolio company to bring the portfolio company into the fund’s controlled group. Therefore, the structure of the Funds’ investments in SBI should have provided the Funds with two layers of protection against any defined benefit liability.
Court Finds Private Equity Investment to Be a Trade or Business
In 2008, SBI filed for bankruptcy and withdrew from the multiemployer pension plan in which it had participated. The pension plan’s trustees sued Sun Capital for SBI’s withdrawal liability. Initially, the Funds prevailed, with the District Court holding that the Funds’ investments in SBI did not constitute a “trade or business.” Thus, the Funds were not members of a controlled group for MPPAA purposes, and could not be liable for SBI’s pension plan withdrawal liability.
The First Circuit overturned the District Court’s decision, setting forth an “investment plus” standard. Under this standard, if a fund satisfies the “investment plus” test, it will be viewed as more than merely a passive investor, and can be held liable for its portfolio company’s defined benefit pension liability. The First Circuit did not lay out a test to determine whether a “plus” factor exists; rather, it used a facts and circumstances analysis. The First Circuit found that a fee offset arrangement between a fund and its portfolio company was sufficient to satisfy the “investment plus” standard. Thus, the fact that fees owed by Sun Fund IV to the Funds’ general partner were reduced by management fees paid by SBI to the general partner provided the “plus” factor, and the court held that Sun Fund IV was engaged in a trade or business with respect to SBI. The First Circuit remanded the case to the District Court to determine whether Sun Fund III also received a fee offset.
On remand, the District Court made the “investment plus” test more basic and easier to satisfy by looking to whether the Funds received any benefit from the management of SBI. The District Court found that one Fund received an offset, and the other Fund received a “carryforward” against management fees that it might be able to use in the future. The District Court found that both the offset and carryforward were economic benefits that a mere investor would not receive. Therefore, the “plus” standard was met, meaning that both Funds were engaged in a trade or business, rather than just passive investing.
Members of the Same Controlled Group
Even if both Funds were engaged in a trade or business, neither of them owned 80 percent of SBI which, under a plain reading of the regulations, would mean that they were not in the same controlled group (and not liable for SBI’s pension liabilities) under the MPPAA. However, the District Court went beyond the ownership percentages, and found that the Funds had formed a “partnership-in-fact” by acting together to seek out the SBI investment and jointly manage it. To determine whether a partnership between the Funds existed, the court focused on the “true intent” of the actors, as well as tax law partnership factors. Ironically, the court found that the decision to split the investment such that neither party owned 80 percent of SBI was, itself, evidence of a partnership. The court held that this implied partnership was the ultimate parent of a controlled group that included SBI. The implied partnership finding resulted in an aggregation of the ownership interests of the Funds, which meant that the Funds owned 100 percent of SBI. (Although it was not discussed in Sun Capital, this analysis would seem to create a basis for extending a portfolio company’s withdrawal liability to the other portfolio companies managed by the “ultimate parent” private equity fund, as well as cause the various companies to be in the same controlled group for purposes of nondiscrimination testing, Affordable Care Act thresholds, successor plan rules, etc.)
What Should Private Equity Firms Do Now?
Based on the most recent First Circuit and District Court decisions, an investor fund should consider the following strategies to minimize potential defined benefit pension liability:
Ensure that any fund owns less than 80 percent of a portfolio company, and seek unrelated investors for the remainder of the portfolio company’s ownership. (Note that typically management members are not unrelated investors for this purpose.)
Factor potential withdrawal liability and other defined benefit plan liability into deal negotiations. Include pension liabilities in the valuation of a target company, and increase scrutiny of a portfolio company’s pension plan funding.
Limit the collaboration or joint activity between any funds and any fund managers that co-invest in a portfolio company, including the following acts which could be considered collaborative between funds:
A coordinated effort among fund managers to appoint board members of portfolio companies (particularly where such members comprise a majority of the board)
Investment fee offsetting between related funds or funds managed by the same fund manager.
Engaging in joint activity with related funds to assess a portfolio company prior to investment.