From a recent Wachtell Lipton memo: “Last Thursday, President Bush signed into law the Pension Protection Act of 2006. The Act makes it easier for hedge funds to attract capital from benefit plan investors and will facilitate non-control investments by private equity and venture capital funds, in each case without the funds’ underlying assets being subjected to the fiduciary and prohibited transaction rules of ERISA and the Internal Revenue Code.
The assets of a fund whose investors include employee benefit plans that are subject to ERISA may be considered to be “plan assets” that are also subject to ERISA, which means that the actions of the manager must comply with exacting fiduciary standards of ERISA. These requirements are not acceptable to most hedge funds and private equity and venture capital funds, which seek to exempt themselves from the rules by:
– qualifying as venture capital operating companies (“VCOC”) or real estate operating companies (“REOC”), which requires an investor, among other things, to have “management rights” with respect to its initial investment and at least a majority of its investments, valued at cost, thereafter; or
– limiting ownership of their equity ownership by “benefit plan investors,” which includes foreign and governmental plans as well as ERISA-regulated private pension plans, to 25% of the funds’ equity interests.
Because qualifying as a VCOC or REOC requires funds to have management rights with respect to certain investments, it is well-suited to private equity and venture capital funds, which typically make long-term investments and obtain management rights. Hedge funds, which typically make short-term investments and therefore do not obtain such rights, largely elect to comply with the rules by limiting ownership of their equity by benefit plan investors.
The New Rules: The approach taken by most hedge funds has economic limitations because “benefit plan investors” include many of the major sources of investment capital. The Act makes this approach more practical by liberalizing the 25% test in two ways:
– The definition of “benefit plan investors” will now exclude foreign and governmental plans; and
– Where benefit plan investors own equity in a fund that invests in a fund of funds, the proportion of the benefit plan investors’ equity ownership in the fund of funds will now be determined based on the benefit plan investors’ proportionate interest in the fund of funds, whereas the existing regulations treated an investment of a fund that flunked the 25% test as 100% held by benefit plan investors.
Impact on M&A: Hedge funds will welcome changes to the plan asset rules, which will provide them with increased capacity to accept additional capital from benefit plan investors and governmental and foreign plans without running afoul of the 25% test. Moreover, because plan money tends to be “stickier” than other forms of capital, hedge funds could have the ability to pursue more longer-term investments than in the past. The increased size of hedge funds, combined with their potential to pursue longer-term strategies, could both fuel more activism by hedge funds and provide them with increased ability to pursue large scale acquisitions.
In addition, some private equity and venture capital funds that have been avoiding treatment as ERISA fiduciaries by qualifying as VCOCs and REOCs will likely consider whether they can meet the liberalized 25% test so that they have more freedom to structure their investments. This could lead such funds to act more like hedge funds than private equity funds have historically acted.
The convergence of these investment strategies and the capacity for multi-faceted approaches by activists who can either agitate or finance an acquisition could pose significant challenges for corporations. We continue to advise corporations to engage in the same kind of preparation for attacks from fund activists as from hostile takeover bids. Careful planning and a proactive approach are critical.”