"Fund-of-funds" partnership investments are becoming increasingly popular alternative investments for pension plans.
But the investments are not without potential liability for public pension funds.
The distinguishing feature of this type of limited partnership investment is the investment portfolio. The fund of funds is a commingled or "pooled" investment vehicle organized to invest in other limited partnership funds. The typical limited partnership fund is formed to acquire equity or debt securities of a specified type or involving a specified industry, such as leveraged buyouts, venture capital, telecommunications, mezzanine financing and the like. By contrast, the fund of funds will hold only interests in those limited partnerships.
These funds can provide several useful functions for both small and large pension investors.
Aggregation means access
By aggregating the capital commitments of its investors, the fund of funds provides a mechanism for smaller pension plans to participate in larger funds that otherwise might require minimum investments beyond their reach. At least in today's cash-flush environment, premier limited partnership fund sponsors often have more investors than they can accommodate, and favor admission of investors with which they have long relationships. The fund of funds provides the smaller pension plans or infrequent investors with access to these investment funds.
Larger pension plans often find it is difficult to make large investments in venture capital funds, which typically have a smaller fund-raising appetite than buyout and other types of investment funds. By investing in a fund of funds focusing on venture capital funds, the larger pension plan can deploy more capital in a cost-effective manner. Finally, the fund of funds also diversifies the participating pension plans' portfolios.
The principal downside to funds of funds has been perceived in terms of the so-called "economics" of the investment because of the additional expense of management fees and other compensation or expenses owed to the general partner who has organized and manages the fund of funds. That expense, however, can be cost-effective in the proper circumstances.
Often overlooked, however, are the significant potential liabilities that might arise because of differences in the way the Employee Retirement Income Security Act applies to a fund of funds.
In general, the minimum threshold for treating the assets of the fund of funds as plan assets of the ERISA limited partners is met when the aggregate interest of all ERISA-governed and public plans (in combination with certain other specified types of entities) equals 25% or more of the fund. If this threshold is met, participation by "benefit plan investors" is deemed to be "significant" and ERISA's plan asset rules apply.
Most alternative investment partnerships in which public plans participate would meet this test. The typical limited partnership, however, is structured to qualify for an exemption from application of the plan asset rules of ERISA, typically qualifying as a venture capital operating company. But the fund of funds that has significant benefit plan investor participation cannot qualify for the VCOC exemption. (This is also the case for certain other types of limited partnerships.)
The absence of a VCOC or other exemption means the plan asset, fiduciary duty and prohibited transaction rules of ERISA will apply.
Public plans beware
This does not mean public plans should not invest in funds of funds. It does mean that public plans investing in these partnerships must take care that the partnership is structured to comply with ERISA. Failure to do so may result in several problems, which could have an adverse impact on the general partner, the partnership or the ERISA limited partners in ways that adversely affect the public plan's investment return. Through its membership on the advisory committee to the fund of funds, the public plan itself could be exposed.
Typically, the documentation for an alternative investment partnership will require the organization of an advisory committee comprising representatives of the limited partners. Duties of the advisory committee can vary, but normally include review of valuations of partnership assets or interests in the partnership and review of conflict of interests transactions and arrangements involving the general partner and its affiliates.
A question of responsibility
Other governance functions can be delegated to the advisory committee and, in the course of negotiations, it is not unusual for the charter of the advisory committee to include required approvals for a variety of circumstances and situations. In the fund of funds, however, the advisory committee must be carefully structured to avoid the risk that the members, or the limited partners represented, may be treated as "fiduciaries" with respect to the ERISA limited partners.
Under ERISA, a plan fiduciary may be identified by looking to the duties that person performs. For example, the general partner of a fund of funds is a fiduciary with respect to the ERISA limited partners "to the extent" the general partner "exercises any authority or control respecting management or disposition of" assets of such ERISA limited partners or "to the extent" the general partner "renders investment advice for a fee or other compensation, direct or indirect," with respect to such assets. In addition, to the extent the general partner or its agent (such as a management company) exercises any "discretionary authority" or "discretionary control" respecting management or administration of the fund of funds, the definition of fiduciary may be met.
Typically, the general partner will acknowledge its fiduciary status in the documentation for the fund of funds. However, to the extent the advisory committee also exercises any authority or control respecting management or disposition of fund of funds assets or exercises discretionary authority or discretionary control over the management or administration of the fund, the advisory committee and its members may also unknowingly meet the definition of a fiduciary with respect to the ERISA limited partners.
Once a person meets the functional definition of a fiduciary with respect to an ERISA-governed plan, that person must discharge such fiduciary duties with respect to the plan in accordance with the fiduciary duty standards of ERISA. Failure to meet the fiduciary duty standards of ERISA may subject the fiduciary to personal liability for losses to the plan resulting from the breach. ERISA also provides for restoration to the plan of any profits of the fiduciary that have been made through use of the plan assets, removal of the fiduciary and other remedies. In addition, under certain circumstances, the fiduciary may be subject to civil penalties of 20% of any amount that is recovered from the fiduciary under a settlement agreement with the Department of Labor or ordered by a court to be paid to the plan by the fiduciary in an action brought by the DOL.
It has been our experience that public plans do not expect to, and are not authorized under their own governing laws to, assume any "fiduciary" status or responsibility with respect to their ERISA limited partners. Therefore, if the public plan wants to participate on the advisory committee but not assume fiduciary status, it is important the documentation for the fund of funds be scrutinized to identify circumstances where investment, management or administrative decisions are being made or approved by the advisory committee.
Costs and liabilities
The capital committed to an alternative investment partnership is available to pay specified expenses of the partnership and to fund indemnity payments to the general partner and its affiliates incurred in connection with the management of the partnership, subject to certain narrow exclusions.
Accordingly, to the extent the partnership or the general partner incurs liabilities or obligations arising under ERISA, the public plan limited partners are responsible for their pro rata share of these costs. In the context of the operation of the fund of funds, these costs may include excise taxes under ERISA and the Internal Revenue Code, should the general partner cause the fund of funds to engage in a prohibited transaction.
Excise taxes may amount to 15% of the amount involved for each year the prohibited transaction continues, with an excise tax of 100% of the amount involved assessed if it is not corrected within a designated period. In general, excise taxes are imposed on any "party-in-interest" (under ERISA) or "disqualified person" (under the revenue code) who engages in the transaction. Correction of a prohibited transaction is accomplished by "undoing the transaction to the extent possible," but in any case putting the plan in a financial position not worse than that it would have been in if the highest fiduciary standards had been met.
Prohibited transactions
Although both ERISA and the code include expansive lists of prohibited transactions, the lists and the relevant definitions are not identical and the available statutory and regulatory exemptions are narrow.
Further, the definitions of "party-in-interest" and "disqualified person" are very broad and include any fiduciary, a service provider to the plan, certain relatives of the fiduciary or service provider, entities in which the fiduciary or the service provider have a 50% interest, and an employee, officer, director or 10% owner of the service provider. The definitions are generally broad enough to include the management company to which the general partner for the fund of funds may delegate the actual management of the partnership.
Therefore, any fund of funds assets transferred to the management company (including the payment of the management fee) may constitute a prohibited transaction unless the "reasonable arrangement" exemption applies. The prohibited transaction rules also include certain restrictions on self-dealing by the fiduciary with respect to a plan, which may affect the general partner's anticipated relationship with the management company and the partnership's portfolio investments.
The fund of funds also may be adversely affected if a particular investment constitutes a prohibited transaction with respect to an ERISA limited partner, which may require the investment be rescinded in order to be corrected. Proper notifications under the partnership agreement could avoid or mitigate this result. Further, if the investment fund being considered as a portfolio investment does not itself qualify for an exemption from the plan asset rules, ERISA requires a "look-through" of both the fund of funds and the underlying investment to determine if a prohibited transaction has occurred with respect to assets of the ERISA limited partners.
Opt-out and withdrawal
Most investment partnerships delegate full investment authority to the general partner, whose expertise is often a key factor in the limited partners' decision to invest.
Public plans, ERISA limited partners and other regulated limited partners (such as bank holding or telecommunication companies) often reserve the ability to opt out of particular investments that would be illegal for the limited partner or would risk the imposition of liability and, if necessary, to withdraw from the partnership.
Although these are essential terms for ERISA limited partners, the exercise of these rights affect the remaining limited partners. In the case of an opt-out, the remaining limited partners might be required to increase their participation, resulting in less diversification, or might be unable to participate in the investment if the general partner determines not to proceed. An opt-out by an ERISA limited partner to avoid violating prohibited transaction rules might be avoided if the partnership agreement contains appropriate terms addressing party-in-interest relationships of the ERISA limited partners.
In some circumstances, withdrawal may be necessary to resolve ERISA violations affecting the ERISA limited partner or the partnership. This is a much more severe remedy because the partnership would buy out the departing ERISA limited partner's interest in the partnership, and the capital of that limited partner no longer would be available for investments. At this juncture, the continuation of the partnership could be put in jeopardy and losses may be faced by all of the investors if assets are sold prematurely to fund the buyout or to liquidate the partnership.
In conclusion, the fund of funds partnership agreement should be properly structured to address the plan asset, fiduciary duty and prohibited transaction rules of ERISA in order to minimize the risks to public plan limited partners. It is critical the public plan and its counsel pay close attention to the fund's compliance with ERISA.
Thomas R. Mueller and Sarah Heck Griffin are partners at Jones, Day, Reavis & Pogue, Los Angeles.
