June 16, 2008


Investors in private equity funds commonly include pension plans that are subject to the Employee Retirement Income and Security Act (“ERISA”).  As a result, unless the private equity fund satisfies one of two available exceptions, the assets of the fund itself would be considered to be “plan assets” subject to ERISA, in which case the fund manager would be required to comply with stringent duties and requirements imposed by ERISA.  Because certain of these duties and requirements conflict with how private equity funds are managed,[1] we will discuss in this newsletter the two commonly used approaches that private equity funds with pension plan investors use to avoid becoming subject to ERISA’s duties and requirements.  All private equity professionals should be familiar with the exception that applies to their fund.

What are the most commonly used exceptions?

To avoid ERISA’s “look-through” rule, which would result in the fund’s assets being deemed to include the “plan assets” of its benefit plan investors [2] and thus subject the fund manager to ERISA’s duties and requirements, private equity funds typically take advantage of one of two exceptions:

  • The 25% exception.  In general, a fund manager will not become a benefit plan fiduciary if benefit plan investors do not hold 25% or more of the value of any class of equity interests in the fund.
  • The VCOC exception.  If benefit plan investors hold 25% or more of the value of any class of equity interests in the fund, the fund can avoid the look-through rule by qualifying as a “venture capital operating company” (a “VCOC”).

Many private equity funds have recently permitted their general partners to choose between the two exceptions.  For example, a general partner may initially decide to utilize the VCOC exception but if at a later date, investments from benefit plan investors turn out to be below the 25% limit, the general partner may decide to use the 25% exception instead.

As mentioned above, the 25% limit must be satisfied separately with respect to each “class” of equity issued by the fund.  Generally, separate classes would be considered to exist if there are significant economic differences in the interests of the fund, such as differing fee structures, liquidity preferences or distribution rights.  Further, side letters that provide benefit plan investors or other investors with special rights may be deemed to create a separate class.  Caution should therefore be exercised when entering into such arrangements.

What tests must a fund satisfy to qualify as a VCOC?

To qualify as a VCOC, a private equity fund must participate more in the management of the companies in which it invests than a typical passive investment fund would.  To confirm that the fund exercises such control, the fund must satisfy two requirements: a “50% test” and an “exercise test.”

  • The 50% test.  At least 50% of the fund’s assets (excluding short-term investments pending long-term commitments or distribution to investors), valued at cost, must be invested in either:
    • “operating companies,” i.e., entities (other than VCOCs) that are primarily engaged, directly or through one or more majority-owned subsidiaries in the production or sale of a product or service other than the investment of capital) with respect to which the fund has “management rights,” or
    • certain “derivative investments.”  Derivative investments include an investment in an operating company as to which the fund’s management rights have ceased as a result of a public offering of securities or a merger or consolidation of the operating company (provided that the merger or reorganization is made for independent business reasons unrelated to extinguishing the fund’s management rights).  Derivative investments can continue to be counted toward the 50% test until the later of 10 years after the date the investment was originally acquired and 3 years after the public offering, merger or consolidation. 
  • The exercise test.  The fund, in the ordinary course of its business, must exercise “management rights” with respect to one or more of the operating companies each year.  “Management rights” are contractual rights directly between the fund and the operating company that allows the fund to substantially participate in, or substantially influence the conduct of, the management of the operating company.  A fund typically obtains its management rights either by:
    • securing a contractual right to appoint a director to the operating company’s board, or
    • obtaining a combination of other contractual rights that collectively qualify as management rights, which are typically included in a shareholders’ agreement to which the operating company is a party or “management rights letter.”  Examples of such rights include a board observer, the right to periodically meet with management and rights to inspect company documents.

The fund must be able to exercise its management rights unilaterally, not jointly with any other person or entity.  Therefore, if the fund is part of a group of investors sharing a right to appoint one or more directors, the group must execute a mutual agreement assigning to the fund the right to appoint at least one director. 

When must a fund pass the 50% test?

A private equity fund must pass the 50% test on the “initial valuation date” and on a pre-selected date during each “annual valuation period.”

  • Initial valuation date.  On the date of its first portfolio investment, a fund must pass the 50% test.  Accordingly, the fund’s first investment must be a qualifying VCOC investment (i.e., it must be an operating company with respect to which the fund has management rights). 
    • If the fund fails the 50% test on the date of its first portfolio investment, it can never qualify as a VCOC.
    • Private equity funds are typically required to provide a legal opinion confirming that the first investment will be a qualifying VCOC investment before benefit plan investors’ commitments can be drawn down for the first investment.
  • Annual valuation period.  The fund must pass the 50% test on a date (pre-selected by the fund) once each year during a 90-day period beginning not later than the anniversary of the fund’s first portfolio investment (the “annual valuation period”).
    • If the fund passes the 50% test on the pre-selected date during the annual valuation period, it will qualify as a VCOC until the close of its next annual valuation period. 
    • If the fund fails the 50% test on any pre-selected annual testing date, it will permanently cease to be a VCOC.
    • Once selected, the annual valuation period generally cannot be altered.  It may be convenient for a private equity fund to select an annual valuation period that coincides with the fund’s first or last 90-day period of its fiscal year.
    • As of the close of each annual valuation period, it is common practice for the fund to deliver to each benefit plan investor a certification confirming that the fund continues to qualify as a VCOC. 
  • Distribution period.  The fund must continue to pass the 50% test on each annual valuation date until it enters its “distribution period” (i.e., the fund’s wind down phase during which it is liquidating its investments).

Although only 50% (or more) of the funds assets must be invested in “operating companies” or derivative investments, most private equity funds try to ensure that most if not all of their investments qualify.  In this way, they can try to ensure that the fund will be in compliance with the 50% test in the future, regardless of the order in which investments are sold.

Can an indirect investment qualify as an investment in an operating company, and thus be a good VCOC investment?

Because qualification as a VCOC requires investments in “operating companies” (or derivative investments), special care must be taken when private equity funds invest indirectly, through one or more intermediate holding companies, in operating companies.  An indirect investment in an operating company will be a “good” VCOC investment in either of the following two ways:

  • The intermediate holding company would qualify as an operating company if the actual business operations are conducted by a “majority-owned subsidiary.”   If not all of a holding company’s lower tier subsidiaries are majority-owned, then an analysis must be done to ensure that the majority-owned subsidiaries comprise the principal business activity of the holding company.  There are no explicit rules for this analysis, but one method that is often used is the following:
    • First, the majority-owned subsidiaries are identified.  A subsidiary will be deemed to be majority-owned if the holding company owns both voting control and a majority of the economic equity value of the subsidiary. The voting control requirement may, in certain instances, be satisfied by securing control or substantial influence over significant management decisions. 
    • Second, an assessment is made of the percentage of equity value, revenue and profits of the holding company derived from the holding company’s equity interests in its majority-owned subsidiaries as compared to the equity, revenue and profits associated with its minority-owned investments (i.e., a facts and circumstances analysis is done as to whether the majority-owned subsidiaries constitute the more significant portion of the group).
  • A fund may also invest in an operating company through a “wholly owned” intermediate company.[3]
    • The fund should retain direct management rights in the actual operating company, notwithstanding the fact that its direct investment is in an intermediate company.
    • For purposes of determining whether the fund wholly owns a company’s equity, any de minimis holdings by the fund’s general partner held solely to comply with federal income tax requirements for classification as a partnership may be disregarded, but otherwise the fund seeking to qualify as a VCOC must be the only other equity holder in the intermediate company.

If you have any questions regarding this private equity newsletter, please do not hesitate to call your Davis Polk contact.

1. Failure to comply with one of these exceptions would subject the private equity fund to ERISA’s strict fiduciary duties and prohibited transaction rules.  ERISA also imposes stringent requirements on how fiduciaries may be compensated and prohibits certain types of performance fee arrangements that are commonly used by private equity funds.

2. Benefit plan investors, as defined in Section 3(42) of ERISA, include any employee benefit plan subject to Title I of ERISA (e.g., U.S. corporate pension plans), (ii) any plan subject to Section 4975 of the Code (e.g., IRAs) and (iii) any passive investment fund whose underlying assets include "plan assets" (generally because plans described in (i) or (ii) above own 25% or more of a class of the investment fund’s equity interests).

3. See DOL Advisory Opinion 95-04A (May 3, 1995).