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ERISA Plan Assets Regulation: 15 years on

For the past 15 years the US private equity industry has been able to structure its funds according to the Plan Assets Regulation, registering as ‘venture capital operating companies' so that they are not subject to ERISA's compliance rules. Patricia Cashman of Testa, Hurwitz and Thibeault discusses the impact of the regulation as well as suggesting improvements.

It has been 15 years since the Department of Labor's Plan Assets Regulation became effective. By clarifying when the manager of an investment entity will (and will not) be treated as a fiduciary, that regulation paved the way for employee benefit plans regulated by ERISA to invest in private equity funds. Under the regulation, fund managers have been able to structure their funds so that their assets would not be treated as 'plan assets' of investing ERISA plans, thus allowing them to operate without being subject to ERISA's tough compliance and fiduciary rules.

Under the regulation, a private equity fund or other pooled investment vehicle will be deemed to hold plan assets unless (i) 'benefit plan investors' hold less than 25% of each class of interests in the fund or (ii) the fund qualifies as a 'venture capital operating company' (a VCOC). Because benefit plan investors (a term that includes governmental and foreign pension plans as well as plans subject to ERISA) are often among the larger private equity investors, reliance on the under 25% exemption is not particularly common. Instead, most private equity funds rely on the VCOC exemption.

In order to qualify as a VCOC, a private equity fund must invest at least 50% of its assets (other than short-term investments), valued at cost, in portfolio companies in which the fund obtains 'management rights', and the fund must actually exercise these rights to some degree. The regulation defines management rights as contractual rights directly between the fund and the company, which permit the fund to substantially participate in or substantially influence the conduct of the management of the company.

The preamble to the regulation indicates that a contractual right to a board seat will satisfy the management rights requirement. In the years since the regulation was issued, however, the Department of Labor has offered little guidance as to what other contractual rights will suffice. Based on an example in the regulation and on Advisory Opinions issued on this topic, the practice has evolved for private equity funds that cannot obtain a board seat to instead obtain from the company a letter agreement or covenant giving the fund certain direct contractual rights. These rights have included, among other things, the right to consult with and advise management of the portfolio company, the right to examine the books and records of the company, and the right to have a representative attend board meetings as an observer. Even though funds need management rights in only 50% of their investments, many funds have made it a practice to obtain management rights in connection with each portfolio investment they make. Because it is such common practice, portfolio companies, particularly those in the U.S., rarely object to granting these rights. For funds that make substantial investments in non-U.S. portfolio companies, differences in business practices sometimes make management rights more difficult to structure or to obtain, but many funds investing outside the U.S. have been quite successful at complying with the VCOC requirements.

Private equity funds also face a timing issue in qualifying for VCOC status. The regulation provides that a fund must satisfy the 50% of assets test for VCOC status on the day the fund makes its first long-term investment. A Department of Labor Advisory Opinion issued in 1989 clarified that a fund cannot qualify as a VCOC prior to that date. Accordingly, unless a fund is able to rely on the under 25% exemption, benefit plans subject to ERISA generally are unwilling to contribute any capital to a fund until on or after the date the fund has made its first portfolio investment.

Funds typically deal with this timing issue in several different ways. The first is to try and arrange for all initial capital contributions to be received by the fund on the same day the first portfolio investment is to be made, taking particular care to ensure that contributions of ERISA plan investors arrive no earlier than such date. Because the timing of the capital contribution and the investment are not exclusively within the fund's control, this method can be unreliable if ERISA plan investors' capital is needed for the first investment. Another method is to delay the capital contributions from ERISA investors until just after the fund's first investment is made. Funds using this method should confirm that the partnership agreement permits the delayed contribution. A third method is for ERISA plan investors to wire their capital contributions to an escrow agent who holds the assets until instructed to release them to the fund on the day of the fund's first investment. This method is more costly than the other approaches, and it requires the negotiation of a formal escrow agreement.

Although the Department of Labor has not frequently audited funds for compliance with the VCOC regulation (we are aware of only one such audit among our clients), ERISA plan investors often require a legal opinion or an annual certificate regarding a fund's VCOC status. As a result, funds generally pay close attention to the requirements of the regulation. For example, many funds routinely seek advice of ERISA counsel when investing in portfolio companies through unusual or complex ownership structures.

In summary, for private equity funds that can qualify as VCOCs, ERISA compliance involves only modest efforts; from the private equity industry's point of view, the regulation has been quite effective. Still, there are a few shortcomings with the regulation. The regulation does not provide any mechanism for a fund to qualify as a VCOC later in its life cycle, even if it had no ERISA investors at inception. Nor is there flexibility to regain VCOC status if a fund inadvertently fails to qualify for a brief period. Finally, the VCOC exemption is not available for private equity funds of funds, which today represent an increasingly large segment of the private equity universe, a segment that offers many advantages to ERISA plans. The VCOC regulation should be updated to accommodate these concerns.

Copyright © 2003 Testa, Hurwitz & Thibeault, LLP. All Rights Reserved.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP.  For more information about Testa, Hurwitz & Thibeault, LLP, please contact info@tht.com or visit the firm's web site at www.tht.com.