Investments By Governmental Pension Plans In Private Equity Funds

Friday, February 1, 2008 - 01:00

Defined benefit pension plans are a world unto themselves. The plans generally provide for an annual benefit equal to a percentage of an employee's compensation multiplied by the employee's years of service. The amount of the annual benefit and the annual compensation considered in calculating the annual benefit are limited by the tax laws. In addition, the plan usually caps the total years of service at a certain number, such as twenty-five or thirty. Funding of the plans through annual employer contributions is based on actuarial assumptions for employee mortality and turnover, increases in compensation, and the investment return on plan assets. If the plan's actual investment return falls below the actuarial assumption, the plan can become underfunded, and the employer must then reduce the underfunding through larger employer contributions or seek to improve investment returns.

To assist the employer in meeting the actuarial assumption for the plan's investment return, plan fiduciaries invest plan assets in a diversified portfolio. In recent years, with the lure of potential high returns, an important class of investments that plans use to achieve the appropriate diversification and value is alternative investments: private equity funds, real estate funds and hedge funds.

Since state and local governments often sponsor defined benefit pension plans, and these plans often have large amounts of capital to invest, governmental plans are a major target class of investors for private equity funds. Indeed, the fund's private placement memorandum often contains a separate focused discussion of the issues that a governmental plan should consider before investing in the fund.

Private equity funds are often structured as Delaware limited partnerships. The partnership's portfolio investments are selected and managed by the general partner, or an investment manager with which the partnership enters into an investment management agreement. The general partner and the investment manager are often controlled by the same persons. The governmental plan is admitted to the partnership as a limited partner in consideration for the plan's capital commitment.

When investing in a private equity fund, governmental plans often face both their own issues that differ from other fund investors as well as concerns similar to other investors. The plan fiduciary usually addresses these issues by negotiating and entering into a side letter with the general partner and the partnership. This article will discuss the key issues that governmental plans address in their side letters.

State statutes or regulations often impose limitations on plan investments. For example, the regulations may impose a leverage limitation on any one investment or class of investments. Plan fiduciaries address these limitations by negotiating an excuse right. This right provides that when the plan fiduciary gives the general partner an opinion of counsel that a proposed partnership investment will violate a plan's investment limitation, the plan is excused from funding the portion of its capital commitment that would be used for the investment, and from having its prior capital contributions used for the investment. In addition, the partnership will not allocate items of income and loss, or make distributions of cash, attributable to the investment to the plan. In response to the plan's request for the excuse right, the general partner usually requires that the excuse right not reduce the amount of the plan's capital commitment.

In recent years, pay-to-play rules limiting the contracts a governmental entity can enter into if campaign contributions have been made to that entity's officials have gained in importance. Under these rules, a governmental plan could be prohibited from investing in a fund in which the fund's controlling entities (general partner, investment manager, investment management professionals of either the general partner and investment manager, and the executives that supervise these professionals) have made campaign contributions greater than a specified amount within a specified time period. The governmental plan seeks the general partner's representation that the prohibited contributions have not been made for the applicable time period prior to the plan's admission into the partnership, and the general partner's covenant that prohibited contributions shall not be made as long as the plan is a limited partner.

The side letter may also address the plan's remedy should prohibited contributions occur after the plan's admission to the partnership. The plan often seeks not only an excuse right, but also the right to transfer its limited partnership interest to a creditworthy investor. In response to the plan's request for a transfer right, the general partner requires that prospective investors execute a confidentiality agreement, and that the transfer will not have an adverse impact on the fund. The adverse events sought to be avoided include running afoul of the registration provisions of the Securities Act of 1933, causing the fund to become subject to the Investment Company Act of 1940, jeopardizing the fund's tax classification as a partnership, or causing the fund to be treated as a publicly traded partnership taxable as a corporation, or the fund's assets becoming plan assets subject to ERISA or similar state statutes. When the fund is a real estate fund, the general partner requires that the transfer will not cause the partnership or any subsidiary to fail to qualify as a real estate investment trust under the tax laws.

Another concern for governmental plans is the need to satisfy state open public records statutes. The general partner desires to maintain the confidentiality of partnership affairs. This desire often conflicts with the statute's policy of free access to information. To resolve this conflict, the side letter usually provides that the governmental plan may disclose historical fund level information including:the fact that the plan has made a capital commitment to the partnership and the year in which the capital commitment was made, the funded and unfunded portions of the capital commitment, the aggregate cash distributions that the plan has received from the partnership, the plan's internal rate of return from its investment in the partnership, the target rate of return from the investment, and the plan's annual allocation of the partnership's management fees and expenses. Furthermore, the plan often covenants that if it receives a request under the open public records statute for additional information, it shall promptly notify the general partner of the request, and identify the information that the plan intends to disclose and the anticipated date of disclosure. The general partner often seeks the plan's covenant to cooperate with the general partner to avoid or limit public disclosure of confidential partnership information.

Governmental plans not only have their own concerns, but also have similar concerns as other investors. Accordingly, the plan virtually always seeks a most favored nation clause in its side letter. This clause provides that if the partnership enters into any side letter with another limited partner that has made a capital commitment equal to or lesser than the plan's capital commitment, and the other limited partner's side letter contains provisions that are more favorable than the plan's provisions under its side letter, the more favorable provisions automatically become part of the plan's side letter unless the plan notifies the general partner to the contrary. The plan also seeks the general partner's covenant to provide the plan with all side letters within a specified number of days after their execution. In addition, to make sure that the negotiated provisions of the plan's side letter are effective, the plan seeks to provide that the side letter supplements the partnership and subscription agreements, and that the side letter controls over any conflicting provisions in these agreements.

Just as a governmental plan seeks to address its own concerns, the general partner seeks to address its own concerns when admitting a governmental plan as a limited partner. A primary concern of a general partner is whether the governmental plan is subject to state laws similar to ERISA. Although governmental plans are exempt from ERISA's fiduciary and plan asset rules, state statutes can have similar rules. As a result, the general partner seeks the plan's representation that the plan's fiduciary has exercised the appropriate due diligence required by state law when investing in the partnership, and that the general partner has not provided any investment advice to the fiduciary in its decision of whether to invest in the fund. The partnership agreement often provides that if the general partner provides an opinion of counsel that the partnership's portfolio companies, or the assets held by the portfolio companies, are treated as plan assets under state law, the partnership may redeem the governmental plan's limited partnership interest. In this manner, the general partner avoids not only having the portfolio companies and their assets treated as plan assets, but also having the general partner treated as a plan fiduciary subject to state law fiduciary duties.

Steven H. Sholk and Cheryl A. Gorman are Directors in the Corporate Department at Gibbons P.C. Mr. Sholk concentrates in the areas of campaign finance, employee benefits, executive compensation, employment and severance agreements, tax-exempt organizations, and immigration and naturalization. He is active with the Employee Benefits Committee of the Section of Taxation of the American Bar Association, and has participated in the comment letters on golden parachutes, Section 409A, equity split dollar life insurance arrangements, and the Worker Economic Opportunity Act. Ms. Gorman concentrates her practice in securities law and corporate transactional matters, including private equity investments, capital raising, venture capital finance, new issue securities, mergers and acquisitions and acquisitions and dispositions of business interest. She counsels clients in public and private securities offerings and assists public companies with their Exchange Act reporting requirements.

Please email the authors at ssholk@gibbonslaw.com or cgorman@gibbonslaw.com with questions about this article.