On March 28, 2016, a Massachusetts District Court ruled that two affiliated private equity funds (Sun Capital Partners Fund III, LP and Sun Capital Partners Fund IV, LP) were jointly and severally liable for the unfunded vested benefits owed to a multiemployer pension fund by its bankrupt portfolio company.
In 2013, the First Circuit ruled that a private equity fund can be a “trade or business” for purposes of ERISA, which struck a blow at the private equity industry’s first line of defense to avoiding pension plan withdrawal liability.
Now, on remand, the District Court ruled that the two funds cannot avoid ERISA pension liability, even though the two funds split ownership of a company 70%/30% (that is, with neither fund owning the threshold 80% required by the ERISA statute). The court found that the economic reality was that the Sun Capital Funds together formed a partnership-in-fact that owned 100% of the portfolio company and thus are liable for the entire ERISA pension liability.
ERISA’s two-pronged test
Two key questions determine whether a private equity fund will be liable for the ERISA pension liability of a bankrupt portfolio company: (1) is the fund engaged in a “trade or business”; and (2) is the fund under “common control” with or does it have a “controlling interest” of at least 80% in the portfolio company.
1. Trade or business. In 2013, the First Circuit determined that Sun Capital Fund IV was engaged in a “trade or business” because, unlike a passive investor, the fund had an “investment-plus” relationship with its portfolio company. On remand, the District Court held that Sun Capital Fund III also was engaged in a “trade or business” under that same “investment-plus” standard based on several factors, including the following:
- The general partners of the two Sun Capital Funds are each controlled by Sun Capital’s two senior managing principals. Those principals are also the co-CEOs of a third Sun Capital entity that advises the two Sun Capital Funds, structures their deals, and provides management consulting and employees to their portfolio companies.
- The Sun Capital Funds’ limited partnership agreements explain that the Funds are actively involved in the management and operation of their portfolio companies and give the general partner of each Sun Capital Fund exclusive and wide-ranging management authority.
- The Sun Capital Funds were able to place employees of Sun Capital Advisors in two of the three director positions at the bankrupt portfolio company.
- There was a direct economic benefit to the Sun Capital Funds that an ordinary, passive investor would not derive: any fees earned by the Sun Capital Advisors or its affiliates from portfolio companies could offset or carry forward against the management fees the Funds otherwise would have paid their general partners for managing the investment in the bankrupt portfolio company.
2. Controlled by or under common control at 80% level. The District Court determined that even though Sun Capital Fund III and Sun Capital Fund IV respectively owned 70% and 30% of the portfolio company, the two funds had created a partnership-in-fact whose collective stakes exceeded the 80% ERISA liability threshold because:
- Supreme Court tax precedent provides that a “partnership” is not limited only to those entities that identify themselves formally as partnerships, but can include any persons that join together for the purpose of carrying on business and sharing in profits.
- Although the Sun Capital Funds were formally independent entities whose investor groups did not completely overlap, the funds ultimately made their investment and business decisions under the direction of Sun Capital Advisors’ senior managing principals.
- Although the Sun Capital Funds prepared and filed separate partnership tax returns, maintained separate financial statements and bank accounts, and had largely non-overlapping sets of limited partners and portfolios of companies, the Funds jointly pursued the investment in this portfolio company.
- Both before and after their joint investment in this portfolio company, the Sun Capital Partner Funds had co-invested in five other portfolio companies using the same organizational structure and did not provide any evidence of making joint investments with other outside investors.
Key takeaways
Although this case almost certainly will be appealed, there are several takeaways to consider:
- The “trade or business” test will most likely apply to a limited partnership private equity fund if the fund’s general partner has its own capital commitment to the fund, if the general partner is owed a management fee that can be offset by portfolio company fees received in connection with its investments, and if the private equity fund derives economic benefits from portfolio company investments more than an ordinary, passive investor.
- The 80% common control test cannot be avoided simply by having two or more affiliated private equity funds structure their ownership in an investment vehicle such that no individual fund’s ownership exceeds 80%, particularly where the funds share a general partner or have a history of investing together.
- Structuring an acquisition where unaffiliated third-party investors (with no history of coordination with the private equity fund sponsor) hold greater than 20% of a portfolio company and have the ability to make their own independent decisions with respect to that investment should allow the private equity fund sponsor (and the unaffiliated third party) to avoid ERISA liability.
A question left unanswered is whether the private equity fund’s other portfolio companies would also be jointly and severally liable for the ERISA liability of the bankrupt portfolio company under the same 80% common control test.
