A recent U.S. court case has significant implications for private equity (PE) funds that make investments in U.S. portfolio companies, and by extension is relevant for institutional investors such as pension plans that may be making investments in such PE funds.

The case indicates that in certain fact situations, a PE fund can be found to be liable for the underfunded pensions of its portfolio companies. This has obvious relevance for PE funds and may be of interest to investors in PE funds, for a few reasons:

  • Liability for underfunded pension plans is an additional category of liability that may result in PE funds generating lower returns. PE funds, particularly those focused on distressed companies, will want to take this potential liability into account when evaluating portfolio investments and, where appropriate, take steps to mitigate the issue (such as by obtaining indemnities from the sellers of portfolio companies). As a due diligence matter, investors in PE funds will want to ensure that a subject PE fund is sensitive to the issue.
  • Most PE funds include an “LP clawback” whereby the fund is able to claw back distributions from limited partner investors. PE fund investors often seek to cap the amount that can be recalled and the time periods during which amounts can be recalled. This pension issue may be seen as a further incentive to cap the LP clawback in these ways.
  • It is possible that liability for an underfunded pension plan may arise after the sale of a portfolio investment by a PE fund. In certain funds, the likelihood of an over-distribution of carried interest to the general partner may be increased. PE funds may expect additional scrutiny by investors of the “GP clawback” provision, whereby the general partner is required to return over-distributions of carried interest.