In connection with the staggering investment losses suffered by hedge funds over the last several months, many hedge fund investors have already sought, or will soon seek, to redeem their hedge fund investments. Most hedge funds place restrictions on when investors may redeem their interests with many of such funds permitting redemptions only once per quarter. According to industry analysts, it is estimated that more than US$40 billion was withdrawn from hedge funds in October alone. (See Matthew Scott, “Hedge Funds Take Beating for Fifth Month in a Row,” Financial Week, November 20, 2008.) Some investors may not only pull money out of a poor performing hedge fund but, also, out of funds that have done well, in order to offset losses elsewhere. (See Louise Story, “Investors Flee as Hedge Fund Woes Deepen”, New York Times, October 23, 2008 at A1.) It has been suggested that, given the prevalence of quarterly-redemption restrictions in a number of hedge funds, investors will redeem an estimated 30 percent of hedge fund industry-wide assets by the end of 2008. (See Suchita Nayar, “Funds of Hedge Funds are Facing a Bad Wake-up Call,” FT.com, October 12, 2008)
Hedge funds often restrict their investors to wealthy individuals and institutional investors, who, in theory, have the resources to understand and absorb the risks involved in investing in such funds, in exchange for the ability to operate without many of the constraints of the regulatory and disclosure requirements imposed on other types of pooled investments (such as mutual funds). In recent years, there has been a trend for pension plan fiduciaries, seeking greater diversification and significant growth potential, to invest pension plan assets in hedge funds and other so-called “alternative investments.”
The 25 Percent Test
In general, under a look-through rule contained in the US Employee Retirement Income Security Act of 1974, as amended (ERISA), and the regulations promulgated thereunder (the “Plan Asset Regulation”), when a plan that is subject to ERISA (e.g., a US private pension plan) or Section 4975 of the US Internal Revenue Code of 1986, as amended (the “Code”) (e.g., an individual retirement account (an “IRA”)), acquires an equity interest in an entity, and that interest is neither a publicly-offered security nor a security issued by an investment company registered under the US Investment Company Act of 1940, the assets of the plan will include not only the equity interest in the entity, but also an undivided interest in each of the underlying assets of the entity, unless an exception under the Plan Asset Regulation and ERISA applies.
One such exception applies if the entity is an “operating company,” within the meaning of the Plan Asset Regulation, which includes a “venture capital operating company” (a “VCOC”). Another exception applies if “benefit plan investors” (e.g., US private pension plans and IRAs) hold less than 25 percent of the value of each class of the equity interests in the entity, disregarding equity interests held by persons (other than benefit plan investors) who have discretionary authority or control over the assets of the entity or who provide investment advice for a fee with respect to those assets and “affiliates” of those persons. This rule is known as the “25 Percent Test.”
For the most part, hedge funds seeking to avoid coverage by ERISA endeavor to comply with the 25 Percent Test. Unlike private equity funds, hedge funds generally will not seek to qualify as VCOCs, largely due to the fact that hedge funds typically will not obtain sufficient management rights in their investments (one of the key requirements for VCOC qualification).
While avoiding ERISA coverage is now easier after the enactment of the Pension Protection Act of 2006 (the “PPA”), which limited the types of plans taken into account under the 25 Percent Test, an increasing number of hedge funds accept coverage under ERISA, especially after the PPA’s addition of the “service provider” prohibited transaction exception, which may facilitate ERISA compliance. More generally, market forces, particularly those causing a concentration of investment capital in pension plans, may cause hedge funds to become willing to be subject to ERISA.
For those hedge funds wishing to avoid ERISA coverage, complying with the 25 Percent Test entails a careful monitoring of each class of the equity interests in an investment fund held by “benefit plan investors.” As a result, a hedge fund must initially determine the percentage of “benefit plan investors” holding equity interests in the hedge fund, either directly or indirectly. Thereafter, a hedge fund must monitor all new investors, transfers and redemptions of interests in the hedge fund to ensure that such new investors, transfers or redemptions will not cause the equity interests held by “benefit plan investors,” either directly or indirectly, to equal or exceed 25 percent If a hedge fund were to fail to meet the 25 Percent Test (and does not otherwise qualify as a VCOC or otherwise meet another exception under the Plan Asset Regulation), the unfortunate result would be that such hedge fund would be deemed to hold “plan assets” and would be subject to the panoply of ERISA rules and regulations. This result would in turn require, for example, that the manager or general partner of a fund act as a fiduciary of the investing pension plans and that consideration be given to whether the fund’s transactions could constitute prohibited transactions under ERISA or Section 4975 of the Code.
Violations of the 25 Percent Test Could Occur
As hedge fund assets will begin to flow back to those investors who initiated redemptions over the last several months, the percentage of “benefit plan investors” that may remain in each hedge fund may change. It is possible that most redemptions motivated by the financial crisis will come from wealthy individual investors, rather than from institutional investors, such as pension plans, since individuals tend to generally have a lower tolerance for investment losses. (See L. Story, “Investors Flee as Hedge Fund Woes Deepen,” cited above, at A1.) For some hedge funds, once redemptions have been made to withdrawing individuals, “benefit plan investors” may end up owning a larger percentage of the fund’s assets and, in some instances, that percentage may exceed the 25 percent threshold.
What Can Be Done?
For hedge fund managers, now it is particularly important to monitor redemptions from their funds to ensure continued compliance with the 25 Percent Test. In the event that a distribution would cause a fund to violate the 25 Percent Test, action should be taken to prevent this from occurring, unless the fund is structured to be ERISA-compliant. The operating documents of hedge funds often contain provisions intended to assist managers from violating the 25 Percent Test. Such provisions can include, for example, (i) preventing non-benefit plan investors from receiving a distribution that would cause the fund to fail the 25 Percent Test and (ii) requiring benefit plan investors to take distributions from the fund if it is necessary for the fund to continue to pass the 25 Percent Test. Failure to take necessary action will, in addition to causing the fund to be subject to the panoply of ERISA rules and regulations, typically cause certain adverse provisions of the hedge fund’s operating document to apply. Such provisions typically include certain cure requirements that, in some instances, could trigger mandatory distributions to certain investors.
Given the number of redemptions that have occurred in the last several months and the possibility that market conditions will continue to sour, resulting in additional investors seeking redemptions, hedge fund managers should review their funds’ operating documents to determine what steps (e.g., prohibiting redemptions or required distributions to certain investors, as described above) they can take to avoid violating the 25 Percent Test and to implement such steps as may become necessary.
For fiduciaries of pension plans who have invested plan assets in hedge funds, now may be a good time to contact each of their hedge fund managers to inquire about compliance with the 25% Test and, in the event of noncompliance, to take action (such as requesting a withdrawal or other action as may be permitted in the fund’s documentation) so as to avoid an investment in a fund that is deemed to have ERISA plan assets. It may also be appropriate to discuss the possibility of allowing the 25 percent level to be exceeded and thereby become an ERISA-compliant fund.
If you are a hedge fund manager or a pension plan fiduciary whose plan’s assets are invested in hedge funds and you would like to discuss the recent market volatility and its possible ERISA-related implications, White & Case would be happy for you to contact us to review your options during this difficult time.