As indicated in Section 10.2.6.d. the Pension Protection Act of 2006 liberalized the "Significant Participation" text for funds with limited partner commitments from investors subject to the Employee Retirement Income Security Act of 1974 ("ERISA"). For purposes of the 25% test, investors which had been counted in that census because they looked like ERISA funds . i.e., State employee benefit plans and off-shore employee benefit plans . are now no longer counted. The only investors counted towards the Significant Participation test are funds directly regulated by ERISA.
Obviously, to avoid the ability of parties so inclined to skate around the rule, there has been historically, and still remains, a 'look through' proscription which impacts, particularly, fund of funds investors. Under the old rule, assume a fund of funds investor included ERISA entities subscribing to 25% or more of the fund-of-fund's committed capital. When the fund of funds investor committed to a buyout or venture fund, the 'look through' rules counted the entire commitment of the fund of funds LP as an ERISA entity for purposes of the 25% test vis- -vis the second tier fund.
In keeping with its liberalizing effect, the Pension Protection Act modified that rule . seemingly favorably . for fund of funds investors. Accordingly, if a fund of fund investor commits, say, $10 million to a buyout fund and ERISA entities' commitments to the fund of funds are 50% of its total commitments, then, instead of counting the entire $10 million against the Significant Participation test at the buyout fund level, the buyout fund now need only count $5 million.
The problem is, of course, that, if the buyout fund is close to the 25% line, it needs to worry about transfers at the fund of fund level. Thus, assume, often counting only $5 million in our hypothetical against the 25% test, the buyout fund is at 24.5%. What happens if a non-ERISA entity in the fund of funds partnership transfers its interest to an ERISA entity? This would put the buyout fund over the limit and require it to recalculate its structure as a VCOC, file as a QPAM if possible . or, worst case, observe the ERISA rules on conflicts of interest, etc. A potential nightmare. The conservative approach, therefore, is to ignore the liberalizing effect of the 2006 Act and count fund of fund investors as a one-hundred percent ERISA entities, unless the fund of funds will commit not to allow any transfers which would disturb the ratio of ERISA to non-ERISA investors at the fund of fund's level.
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
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