Private equity firms have typically framed themselves as investment vehicles rather than as actual business managers. But in March, Judge Douglas Woodlock of the U.S. District Court for the District of Massachusetts upended that idea. In a ruling on the Sun Capital Partners III, LP, Sun Capital Partners III QP, LP, and Sun Capital Partners IV, LP, v. New England Teamsters and Trucking Industry Pension Fund case, Judge Woodlock found that a private equity firm met the test for being considered a trade or business.
This decision, which leaves Sun Capital Partners on the hook for retiree pensions at one of its portfolio companies, makes general partners liable for such businesses in many of the same ways that CEOs are. It could also have an impact on pension plans at other private equity firm–owned companies.
Sun Capital had no comment on the ruling. The Boca Raton, Florida–based company has been fighting in court since 2013 to avoid paying pension liabilities at Scott Brass, a Rhode Island metals manufacturer. Jerome Schlichter, a founding managing partner at the St. Louis law firm Schlichter Bogard & Denton who represents unions in employment benefits cases, says other pensioners could use the case as a model for their own claims.
“The lesson we should learn from this case is that the court isn’t just looking at the form of a private equity transaction,” Schlichter notes. “They’re looking at the substance of that deal.”
To determine who controls a portfolio company, a judge looks at both ownership and who is active in the business; the latter depends on how the deal and the company are structured. Private equity firms have avoided the appearance of being active in portfolio companies by leaving the CEO in place or installing a new one more aligned to the general partner’s interests. But federal ERISA legislation includes the so-called investment-plus standard: Even if a private equity firm relies on traditional investment fund structures, when it comes to control the court will consider which party is most active, regardless of the structure.
When $9.1 billion Sun Capital bought Scott Brass in 2006, the metals maker was required to contribute to the New England Teamsters & Trucking Industry Pension Fund, but it stopped doing so in 2008, triggering a withdrawal liability under federal retirement rules. The Teamsters argued that, as the company’s owner, Sun Capital should cover the pension payments.
In 2013 the U.S. Court of Appeals for the First Circuit sided with the union, holding that a private equity firm can be liable as a trade or business for the withdrawal liability of its portfolio company if any of its funds received economic benefits from their investment. The case has been on appeal since then. In March, Judge Woodlock said that the way Sun Capital structured the Scott Brass transaction made it a “partnership in fact,” which meets the investment-plus test for active control.
The basic structure of the investment is common in private equity: Sun Capital spread it across two funds and used a holding company to make the purchase. Beyond the acquisition Sun Capital’s funds offset the management fees that they owed to the holding company by taking other fees from Scott Brass. Given that two funds joined forces to look for deals and set up fee offsets, the structure met the investment-plus test, the judge ruled.
“Because of the possible application of common control principles, direct investors investing together need to be mindful of how they are organized and operate,” says Ronald Richman, a New York–based partner and co-head of the employment and employee benefits group at law firm Schulte Roth & Zabel. Common control principles are a legal standard by which courts determine who really owns and controls an entity. “GPs should consider all of the implications here,” Richman concludes.
One major consequence could be a drop in valuations, according to David Fann, president and CEO of TorreyCove Capital Partners, a San Diego, California–based private equity consulting firm. When private equity firms look at potential portfolio companies, any pension liability could now be reflected on the balance sheet as a cash flow risk, Fann says. “I think deal teams have to consider the risks here, but so do investors,” he warns. “If the valuation is lower, that will impact returns.”
The notion that private equity is purely an investment gets harder to support as general partners create internal consulting outfits and advisory groups and become organizations that are in the business of buying and selling companies, Richman observes. “It is definitely possible that other courts will use the investment-plus test, or even a more rigorous test, to find that private equity firms are trades or businesses,” he says, adding that he wouldn’t be surprised to see more such cases, especially in industries under financial stress.
Attorney Schlichter agrees: “When private equity comes into a distressed company, the active role required of private equity in a turnaround makes it that much easier for the court to say, ‘This is a business,’” he notes.The Sun Capital ruling also paves the way for a player like the federal Pension Benefit Guaranty Corp. to become more aggressive in targeting private equity owners for unpaid pension insurance premiums; likewise, it could help the PBGC to determine who should pay pension liabilities if a general partner has struck a deal similar to the Scott Brass purchase. If the Internal Revenue Service adopts the court’s view of private equity, it might change how carried interest is treated in the tax code, which could have material implications for firms and their investors.
Broadly speaking, private equity firms market themselves as active investors, TorreyCove’s Fann explains. “But many of the investment standards in these rules treat investments as purely passive vehicles, so there is a tension there,” he says of ERISA and other legislation, predicting that it will get tougher for firms to claim a passive role. “It’s a symptom of a maturing industry, and the industry may have to change.”
