How Can Hedge Fund Managers Accept ERISA Money Above the 25 Percent Threshold While Avoiding ERISA's More Onerous Prohibited Transaction Provisions? (Part One of Three)

The hedge fund industry is at an interesting juncture.  Various studies suggest that assets under management (AUM) by hedge funds globally are poised to rebound dramatically from their 2009 nadir over the coming four years and beyond.  For example, an April 2010 survey by Credit Suisse's Prime Services business of institutional investors representing approximately $1 trillion projected that the hedge fund industry will grow from an estimated $1.64 trillion in AUM at the end of 2009 to $1.97 trillion by the end of 2010.  Similarly, an April 2009 survey by BNY Mellon and Casey Quirk forecast that global hedge fund AUM would reach $2.6 trillion by the end of 2013.  At the same time, we at the Hedge Fund Law Report have talked to an appreciable number of hedge fund managers − including startup managers and established managers with admirable track records − who have noted that the fundraising environment remains challenging.  In other words, a significant volume of assets is poised to move into (in some cases, back into) hedge funds, but that move has just begun.  Why this disjunction between survey results (suggesting large imminent inflows) and anecdotal evidence on the ground (suggesting that those inflows remain in the offing)?  One answer may be the nature of the new or returning investors.  According to the BNY Mellon-Casey Quirk study and other studies, a substantial portion of the near-term net inflows are expected to come, directly or via funds of funds, from corporate pension funds and other institutional investors subject to the Employee Retirement Income Security Act of 1974 (ERISA).  This is patient, judicious and sticky money: ERISA investors generally engage in lengthy and rigorous due diligence and take a relatively long time to make an investment decision.  But once they invest, they tend to stick around.  In short, the gulf between projected and actual inflows into hedge funds is consistent with survey findings suggesting that ERISA investors will comprise a growing proportion of an increasing hedge fund asset base, and it is consistent with the deliberate investment approach of many ERISA investors.  One key take-away for hedge fund managers who want a piece of the new asset pie: avoiding ERISA may no longer be a viable option.  However, the purpose of this article (and two companion articles to follow) is to illustrate why becoming subject to ERISA may no longer be such a bad outcome.  That is, heretofore, hedge fund managers generally have balanced the fee and long-term commitment benefits of accepting "substantial" ERISA investments, on the one hand, with the operational and investment restrictions and compliance and administrative burdens imposed by ERISA, on the other hand.  Many managers have concluded that the burdens outweigh the benefits, and thus have scrupulously kept investments by benefit plan investors below 25 percent of any class of equity interests issued by their hedge funds, thereby avoiding application of ERISA.  However, a robust list of "class exemptions" from the prohibited transaction provisions and other restrictions of ERISA offers to mitigate the operational and investment burdens imposed by ERISA on hedge fund and managers.  Notably, the Qualified Professional Asset Manager (QPAM) exemption and the service provider exemption permit hedge fund managers to engage in many transactions that otherwise would be prohibited by ERISA.  In short, the various class exemptions enable a hedge fund manager to exceed the 25 percent threshold while avoiding many of the more onerous provisions of ERISA.  If the Hedge Fund Law Report were inclined to use cute titles, we might have called this article series: "Class Exemptions or: How I Learned to Stop Worrying and Love ERISA."  As indicated, this article is the first in a three-part series.  This article discusses the general rules under ERISA, the plan asset regulations thereunder and relevant sections of the Internal Revenue Code (IRC) governing when a hedge fund may be deemed to hold plan assets thereby subjecting the fund and its manager to ERISA.  Importantly, this article also discusses the three exceptions to the general rule, focusing on the one exception typically relied upon by hedge funds to remain outside of the ambit of ERISA: the 25 percent test.  In particular, this article provides detail on the definition of "benefit plan investor," and how that definition was narrowed (and thus how hedge fund ERISA capacity was expanded) by the Pension Protection Act of 2006 (PPA); the treatment by a hedge fund of benefit plan investors in hedge funds of funds or insurance company general accounts that invest in the hedge fund; the formula for calculating the percentage ownership of benefit plan investors; the treatment of investments by manager personnel when calculating that formula; the potentially counterintuitive method of defining a "class" of equity interests for ERISA purposes, including discussions of the implications in this context of side pockets and side letters; when and how to recalculate the 25 percent test; the interaction of the 25 percent test and secondary market transfers of hedge fund interests; and disclosure and mandatory redemption considerations.  The second article in this series, to be published in next week's issue of the Hedge Fund Law Report, will discuss the most important consequences to a hedge fund manager of becoming subject to ERISA and the repercussions for a hedge fund manager of violating the fiduciary duty, prohibited transactions or other provisions of ERISA.  And the third article in this series will detail ten class exemptions and other exemptions that hedge fund managers may use to avoid the various operating and investment restrictions of ERISA, as well as potential changes to ERISA and the rules thereunder.

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