A Court Decision Lifts the Curtain on the Private Equity Business
Quite often, private equity firms acquire companies with unfunded pension liabilities. This isn’t surprising, since many PE firms are looking to buy and turn around troubled companies. As you can imagine, companies with serious operational challenges often wind up deferring or ignoring their pension obligations. When private equity acquires these businesses, it frequently attempts to eliminate the pension plans. If the business fails, they simply let the Pension Benefit Guarantee Corporation (PBGC, a government entity) pick up the obligation.
The US Court of Appeals for the First Circuit has thrown a monkey wrench into this standard maneuver by ruling that Sun Capital, a private equity firm, may have an obligation to fund the pension obligation of one of its bankrupt portfolio companies. I’ll explain the court’s rationale and its implications in a moment. However, before we get to that, you need to appreciate the irony of this situation.
Private equity firms, like Sun Capital, get a great of their capital from public pension plans. The public plans are, of course, investing in private equity in order to earn higher returns and prevent their pension liabilities from growing. Over the past month, I’ve written repeatedly about North Carolina’s objective of increasing its alternative investment exposure in order to generate higher investment returns and protect its defined benefit plan. By investing in PE, public pension plans are attempting to profit at the expense of their corporate pension counter-parts. In order for many PE firms to drive returns for their investors and themselves, they feel compelled to disassemble or walk away from the corporate pensions of their portfolio companies. I’m sure public pension plans would rather not think about the consequences of their private equity investments to private sector workers and retirees.
The First Circuit has taken the view that Sun Capital is not merely a passive investor in Scott Brass, the portfolio company that went bankrupt under the Employee Retirement and Income Security Act (ERISA). Therefore, as an active participant in the business, they have an obligation to fund Scott Brass’ defined benefit plan, rather than leaving it to the PBGC. Victor Fleischer, a reporter for DealB%k in The New York Times, does a great job of laying out some of the broader implications of the court’s decision. If private equity isn’t deemed a passive investor, then as Mr. Victor intimates, the firm’s investors might be liable for all sorts of things, including taxes, if a court were to extend the First Circuit’s logic to statutes beyond ERISA.
In recent years, private equity firms have been touting their hands-on approach to managing their portfolio companies. They’ve been trying to convince investors and politicians that they aren’t merely financial engineers. Perhaps their attempts to demonstrate operational proficiency will wind up undermining their ability to limit their liability to their portfolio businesses. If the First Circuit decision is upheld and expanded, it could change the private equity business model. However, this is just one court decision, and the PE industry has the money and political influence to wage an effective war against this decision.