Commentary: New ‘investment-plus’ test poses risks to private equity investors

A federal appellate decision involving a private equity firm and a multiemployer pension plan has dramatically changed the legal landscape. Now that the U.S. Supreme Court has declined to hear the case, MEPPs are sure to pattern their claims after this holding and private equity firms should be aware.

The ruling is a reminder that, for private equity funds, opportunities and distinct risks exist when investing in companies with a unionized workforce that participate in a MEPP. For some, the possibility of withdrawal liability — an unfamiliar concept — presents an unacceptable risk. But private equity firms that understand withdrawal liability and how to mitigate associated risks can access a marketplace of prospective portfolio companies with less competition among buyers. Strategic planning and extensive due diligence are essential, as well as tailoring the investment structure and vehicle, especially as MEPPs advance more inventive theories to recover withdrawal liability.

When an employer that contributes to an underfunded MEPP partially or totally ceases to contribute, the employer is responsible under ERISA for its pro rata share of the MEPP's unfunded vested benefits at the time of the withdrawal, subject to certain exceptions and adjustments. This amount, assessed upon the employer, is referred to as withdrawal liability.

A withdrawal occurs if: the employer ceases operations; the union is decertified or disclaims interest; the obligation to contribute to the MEPP is bargained out of the collective bargaining agreement; or there is a sale of assets.

For private equity investors, the most common event of withdrawal is the bankruptcy of a portfolio company. When a business fails and ceases to contribute to the MEPP, it has withdrawn, and is then responsible for its withdrawal liability. A failed business, however, typically has no assets from which the MEPP can recover.

Any trades or businesses "under common control" of a contributing employer are also liable when an employer withdraws from a MEPP. When a business fails, MEPPs will seek to recover from those controlled group members.

This is how private equity funds become defendants in actions to recover unpaid withdrawal liability.

Under tax law, and for certain purposes under ERISA, private equity funds had been considered not to be engaged in a "trade or business." Rather, they have been considered a passive investment vehicle, with no employees, no involvement in the day-to-day operations of portfolio companies and no income other than passive investment income such as dividends, interest and capital gains.

That changed in 2007 when the Pension Benefit Guaranty Corp. appeals board held that a private equity fund and its portfolio companies may be deemed a trade or business based on the regularity of the private equity fund's investment activities. Observers suggested the PBGC's decision could not withstand judicial review.

But in 2019, the PBGC's rationale gained traction with the 1st U.S. Circuit Court of Appeals. In Sun Capital Partners III LP vs. New England Teamsters & Trucking Industry Pension Fund, a portfolio company's bankruptcy triggered a withdrawal liability of about $4.5 million. The Teamsters Pension Fund alleged that the Sun funds were a trade or business under common control with the portfolio company for purposes of withdrawal liability.

The 1st Circuit adopted the PBGC's standard and held that a private equity fund could be a trade or business if, unlike a mere passive investor, it is actively engaged in the management of portfolio companies. Applying an "investment-plus" test, the First Circuit found that the facts showed active involvement in the management of the portfolio company through agreements and memos that explicitly said the general partners of the private equity funds had wide ranging management authority over portfolio companies. The private equity funds also received a management fee, something an ordinary passive investor would not.

Having established that the Sun funds were engaged in a trade or business, the analysis turned to whether they were a controlled group member.

A "controlled group" is generally two or more "trades or businesses" that are under "common control." Under ERISA all "controlled group" members are jointly and severally liable for the withdrawal liability of any controlled group member. For private equity funds, the more likely arrangement giving rise to a controlled group is a parent-subsidiary relationship, which occurs where one entity owns 80% or more of the other.

In Sun Capital, the ownership interests were such that none of the private equity funds individually owned more than 80% in the portfolio company.

The Teamsters Pension Fund advanced the novel argument that an implied "partnership in fact" existed between the private equity funds such that their individual ownership interests should be aggregated, which together would exceed 80%. Rooted in tax law, a partnership in fact exists where eight factors are shown, and if the "true intent" of the investors was to coordinate their actions with an "identity of interest" and "unity of decision-making."

In a highly fact-sensitive analysis, the First Circuit found that, on balance, a partnership in fact did not exist.

The First Circuit found compelling that the limited partnership agreements expressly disclaimed any partnership relationship; the creation of a limited liability company undercut the claim that there was an intent to form a partnership; each filed separate tax returns; each maintained separate financial records and bank accounts; they did not invest in the same portfolio companies in parallel to one another at fixed or variable ratios, evidencing "independence in activity and structure;" and the limited partners in the Sun funds differed.

In sum, the Sun funds were found to be a trade or business, but did not maintain the 80% ownership necessary to impose controlled group liability.

In October, the U.S. Supreme Court declined to hear an appeal, ending 10 years of litigation.

While the First Circuit's "investment-plus" test has not been adopted by any other circuit, it is sure to be tested. Private equity firms with investments in portfolio companies that contribute to MEPPs should review their arrangements and consider restructuring in light of this holding. For those exploring such opportunities, advance planning is key to insulate against risks.

Michael G. McNally is a partner in the Minneapolis office of Fox Rothschild LLP. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.