What Every Private Equity Fund Manager Should Know About ERISA0

What is ERISA?

The Employee Retirement Income Security Act of 1974 (“ERISA”) protects the interests of employee benefit plan participants by establishing strict standards of conduct for “plan fiduciaries” – i.e., persons who exercise authority or control over the management or disposition of plan assets or who receive a fee for providing investment advice to a pension plan – and requiring disclosure of financial and other information concerning the plan to benefit plan participants.

Why fund managers should care about ERISA?

Employee benefit plans have historically been one of the largest sources of capital for private equity funds. However, the statutory framework imposed by ERISA is extremely strict and is, for all practical purposes, incompatible with the business model of most private equity funds. In particular, ERISA imposes a duty on plan fiduciaries to discharge their responsibilities solely in the interests of the plan participants and “to act with the care, skill, prudence and diligence that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of like character.” Although fund sponsors already have fiduciary duties to their limited partners generally, the duty imposed on plan fiduciaries under ERISA is more strict and may be particularly difficult to comply with insofar as private equity funds frequently pursue high-risk investment strategies and make decisions on the basis of a variety of objective and subjective factors.

ERISA also significantly limits the transactions that a plan asset vehicle may enter into with persons having specified relationships with the plan (including, e.g., any person providing services to the plan and their employees) irrespective of whether such transactions are prudent or fair. Given the breadth of these so called “prohibited transactions” and the potentially large number of sponsor entities/persons who may be “parties in interest” to the plan, compliance with these provisions may be extremely difficult for most funds.

Finally, ERISA imposes limitations on the type of incentives fees and other performance-based compensation that may be paid to plan fiduciaries, including requirements that any performance fee formula take into account both realized and unrealized gains and losses and that assets for which market quotations are unavailable be independently valued by persons appointed by the pension plan.

How do funds avoid regulation under ERISA?

Private equity funds that invest ERISA money (so called “plan assets”) may be deemed to be plan fiduciaries under certain circumstances. In order to avoid having its assets deemed “plan assets” under ERISA, and thereby avoid being classified a plan fiduciary, a fund will generally attempt to ensure that: (i) participation by “benefit plan investors” in the partnership is not “significant” – i.e., “benefit plan investors” represent less than 25% of any class of equity interests in the partnership, excluding interests owned by any person and/or his or her affiliates having control over the fund’s assets (this is often referred to as the “25% Test”) or (ii) the fund qualifies as a Venture Capital Operating Company or “VCOC” because the first investment by the partnership and at least 50% of the partnership’s assets, valued at cost and tested on an annual basis, are invested in “venture capital investments,” and the fund actually exercises “management rights” with respect to at least one such investment during the applicable twelve-month period.

Why fund managers dislike the VCOC Rules?

A good VCOC investment is an active investment in an operating company, where the investor has management rights in the business – i.e., rights entitling the investor to “substantially participate in, or substantially influence, the conduct of the management of the operating company.” While this describes most traditional private equity transactions, the test may be more difficult to meet in certain types of transactions. The right to appoint a director to a company’s board is per se evidence of a good VCOC investment. Absent the right to appoint a director, whether or not an investment is a good VCOC investment is a facts and circumstances test, with which there may be varying degrees of comfort. In cases where a fund does not have the right to appoint a member to the board of directors of the company, funds typically seek a management rights letter, in which the company acknowledges that fund has certain information and consultation rights that are similar to the rights a board member would have. Even if the fund has the right to appoint a board member, there may complications and these problems often arise in club deals (where a consortium may all have rights to a limited number of board seats) or in debt deals (where the investment may not be directly in an operating company).

When relying on the VCOC rules, a fund can have up to 50% of its assets in bad VCOC investments, where the fund does not have management rights. However, the 50% test must be met on an annual basis, meaning that a fund may run afoul of the rule if it disposes of too many VCOC compliant assets, and is left with more than 50% bad assets.

Despite these shortcomings, many funds continue to rely on the VCOC rules either to avoid having their assets deemed plan assets or as a back-stop to the 25% Test.

Why fund managers like the 25% Test?

Particularly since the 2006 amendments to ERISA, the 25% Test is easier to comply with and involves relatively less uncertainty for the fund sponsor. ERISA was amended in 2006 to provide that funds seeking to rely on the 25%Test need only count the commitments of plans that are actually governed by ERISA, i.e., private pension plans, when calculating equity participation by benefit plan investors. As a result, it is no longer necessary to take into account monies committed by large public pension plans or foreign pension plans. In addition, prior to the 2006 revisions, a fund of funds with greater than 25% benefit plan investor participation would have all of its assets deemed plan assets for purposes of the underlying fund’s 25% Test. Now, only the portion of such fund of fund’s money that is subject to ERISA is counted when determining if the underlying partnership has less than 25% plan assets.

How are benefit plan investors identified?

The benefit plan status of each investor is determined by reviewing the ERISA-related questions in the investor suitability questionnaire (the “ISQ”), and should be updated through the final closing on the investor-tracking worksheet being used for the fund on an ongoing basis. While you will likely become quite adept at evaluating investor responses in the ISQ, you should always have these sections reviewed by an ERISA lawyer, particularly where an investor has indicated that all or part of the money that will fund its commitment is plan money.

What assurances are given to the limited partners that the fund is in compliance with ERISA?

ERISA investors will frequently negotiate for certificates and/or opinions from the general partner that the fund is in compliance with its applicable ERISA exemption(s). For example, if the partnership is relying on the 25% Test, the general partner may be required to provide certificates and/or opinions stating that the fund has complied with such exemption on the initial closing, the final closing and at the end of each annual valuation period. Similarly, many funds permit ERISA partners to withhold their initial capital contributions to the fund until the general partner has provided an opinion of counsel stating that the fund’s first investment is a good VCOC investment. Consequently, it is important to keep track of benefit plan investor participation on an ongoing basis so that the ERISA team can prepare the required certificates/opinions.

What about transfers to benefit plan investors?

The rules that apply to plan assets do not go away at closing. Funds that hope to continue to fall under the exemptions provided by the 25% Test and the VCOC rules must continuously monitor their investors. In the case of the 25% Test, limited partner transfers must be carefully monitored. If a transferee is a benefit plan investor, you must be sure that (i) the transfer will not cause the fund to breach the 25% threshold, and (ii) that the new fund percentages are noted so that they can be accounted for in the case of future transfers.


While fund managers face many challenges is tracking investors and ensuring compliance with various securities and other regulations, it is important that they pay special attention to the ERISA rules governing investments from benefit plan investors including the 50% VCOC test and the 25% Test. Failure to comply with these and other ERISA rules can significantly affect the tax treatment of fund assets.

For more information on any of the topics covered in this article please contact one of our attorneys at contact@rbernardllp.com or visit our website at www.rbernardllp.com to learn more about our practice. Follow us on Twitter.

Leave a Comment