Will the Sun Capital Case Transform Private Equity?

In what seemed like a promising investment in 2006, Sun Capital Partners acquired 100 percent of Scott Brass, Inc. (SBI). Over time, however, the investment yielded a bankrupt company, a civil lawsuit, and a ruling that may impact the future of private equity.

On July 24th, the United States Court of Appeals for the First Circuit ruled that “at least one of the private equity funds which operated SBI, through layers of fund-related entities, was not merely a ‘passive’ investor, but sufficiently operated, managed, and was advantaged by its relationship with its portfolio company.”

The shifting of a fund from a “passive investor” to a “trade or business” means that “the activities of the management company should be attributed to the fund and its investors for ERISA purposes,” explained Victor Fleischer.

The extension of responsibility from the firm to the fund could create new challenges for private equity firms from both a tax and legal perspective — if the ruling gets extended beyond the purview of ERISA. The ruling has left some open-ended questions for private equity firms and deal professionals.

Should you be worried about the tax implications?

Defining a private equity fund as a trade or business could “collapse a legal structure aimed at keeping the actives of the fund manager legally separate from the fund’s investors,” explained Victor Fleischer. The changed model “may open the door to much higher taxes for private equity funds and their investors.”

The likelihood of these tax implications is very uncertain. The court emphasized that the current ruling – and related analyses and conclusions – should only be applied within the scope of ERISA’s withdrawal liability provisions, and not beyond.

However, if the ruling is broadened to a federal level, LPs may be faced with “unrelated business income tax (UBIT) or withholding taxes, respectively;” foreign LPs may also face federal and state taxes. For GPs, profits could now be potentially taxed as ordinary income, instead of capital gains. In an already tax-sensitive environment, increased taxes on both the LP and GP front could spell difficulties for the traditional PE model.

Will there be implications for the rest of your portfolio?

In an analysis of the ruling, Skadden, Arps, Slate, Meagher & Flom LLP raised some questions about how a “trade or business” label could impact the entirety of a firm’s portfolio. The white paper explained, “Although not directly addressed in the decision, it logically follows that once a PE fund is determined to be a member of a portfolio company’s controlled group, any other portfolio company in which the PE fund owns an 80 percent or greater interest could also be considered a member of that controlled group.”

As a result, “advisors to PE funds will need to consider carefully the potential financial impact, both on the PE fund and its other portfolio company investments, of any investment in a portfolio company that maintains or contributes to a multiemployer plan or single employer pension plan.”

If there are indeed implications for the entire portfolio, new strategies for managing across funds will need to emerge. While portfolio companies could be grouped to take advantage of certain pension qualifications, “membership in the controlled group would expand each time the PE fund acquired a controlling interest in another portfolio company, and both the PE fund and the other portfolio companies would be exposed to the pension plan liabilities of each portfolio company.” Will private equity firms begin to sell controlling shares to avoid the extra risk? Could be a good way for other PE firms to burn up some of their unused dry powder.

What will unfunded pension liabilities mean for valuations and exits?

If private equity funds are now considered trade or business, and are liable for unfunded or underfunded pensions, companies with such pensions became much riskier investments. As a result, “firms must consider the greater risk of unfunded pension liability when valuing targets,” said Fleischer. The consideration of greater risk will likely come in the form of deeper due diligence and lower price tags — which could prove difficult for exiting portcos.

Some firms may try to bypass the risk entirely. Previously, “many PE fund sponsors [sought] to minimize exposure to pension liabilities by strategically apporting ownership of a portfolio company among two or more PE funds, such that no single fund owns a controlling interest,” explained the Skadden paper.

However, per the ruling, “it appears this strategy could ultimately prove ineffective if PE funds holding a combined 80 percent or greater interest were determined to be acting as a joint venture or partnership in connection with their investment.”

If firms cannot split an investment between their funds, could they split investments between multiple firms? Maybe club deals — despite the negative press last year — could provide a viable alternative for funds looking to avoid controlling interest and the associated pension risks.