Generally speaking, when legislators pass new law without considering the needs of the private equity industry, it is bad news. However, this summer, the new US Pension Protection Act of 2006 bucked the trend - tucked away in the legislation was a provision that will benefit many private equity fund managers who take commitments from US pension fund investors.
When admitting US investors to a fund, it is critical to establish whether any of them are subject to the US Employee Retirement Income Security Act of 1974, commonly known as ERISA. If any US investor is subject to ERISA, to avoid being subject to onerous fiduciary obligations, the fund manager must ensure that either:
As many fund managers will know, ensuring that a fund qualifies as a VCOC is burdensome and can, in some cases, restrict the investment opportunities open to the fund. Better, if possible, to satisfy the 25% test - and the new Act makes this easier in two ways.
First, the definition of a "benefit plan investor" has changed. Previously, the definition included not only employee benefit plans subject to ERISA, but also other employee benefit plans such as government plans and foreign (that is, non-US) plans. So, if an ERISA investor held only 1% of the fund, but non-US pension plans held 24% or more, the fund would have to qualify as a VCOC to avoid being subject to the requirements of ERISA. In addition, it was often difficult to establish whether non-US investors were, or were not, benefit plan investors within the meaning of the US definition. The new definition now excludes government plans and foreign plans, making it both easier to apply the test (because it is easier to establish who is a benefit plan investor) and easier to satisfy it (because fewer investors will count towards the 25%).
Second, when applying the 25% test, funds of funds with some ERISA assets will generally count for less under the new Act. Under the old rules, if, say, 50% of the amounts invested in a fund of funds were ERISA assets, the fund of funds would be subject to ERISA (because it would not satisfy the 25% test), and the whole of its investment in an underlying private equity fund would count when applying the 25% test to that underlying fund. Under the new rules, the fund of funds is still an ERISA investor, but only 50% of its investment (being the percentage of the fund of funds held by benefit plan investors) will count when applying the 25% test to the underlying fund. This should also make the 25% easier to satisfy for many private equity funds.
As any fund manager responsible for VCOC compliance will testify, this is good news.
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