Pension investments bring new opportunities and some challenges
Care must be taken in cases where pension funds invest directly in US renewable energy projects to avoid turning the projects into “plan assets.”
If the projects turn into “plan assets”, then burdensome legal obligations administered by the US Department of Labor will come into play.
US pension funds control more than $32 trillion in assets.
Norman Anderson, chairman and CEO of CG/LA Infrastructure, wrote in Forbes in late December that they could be “utterly transformative” for US infrastructure if even only a small fraction of the amount they have to invest were put into the sector.
Pension plans have invested in US infrastructure for many years by investing in private equity funds that invest, in turn, in projects or project developers. Some larger pension plans have been more likely lately to invest in projects directly.
The climate initiatives being launched by the Biden administration and the eagerness of pension fund and other institutional investors to invest in ESG assets may accelerate this trend.
Plan Asset Consequences
US pension plans are subject to strict regulation by the US government. This regulation poses traps for the unwary and imposes constraints on how projects with equity from pension funds are structured.
Non-US pension funds are not subject to the same constraints.
The US Employee Retirement Income Security Act of 1974 — ERISA, for short — treats any assets in which a US pension plan takes an equity interest potentially as “plan assets” unless an exemption applies.
If a project company, tax equity partnership or project becomes a plan asset, then strict ERISA requirements apply, including the need to comply with pension fiduciary duties, restrictions on certain transactions between related parties, fee disclosure, other reporting and disclosure, bonding and limits on fees paid to managers. In certain cases, significant penalties may be imposed and, in rare cases, the US Department of Labor may step in to unwind the transaction or investment.
Most renewable energy projects are owned through tiers of entities.
At the bottom of the ownership chain is a special-purpose limited liability company that owns the project. This project company is usually “disregarded” — or ignored — for federal income tax purposes. Another limited liability company usually sits immediately above the project company. It is usually treated as a partnership for tax purposes and may have two or more owners. The project developer or “sponsor” is one. The other may be a tax equity investor. A pension plan might invest in an upper-tier partnership with the sponsor and then that upper-tier partnership owns the sponsor interest in the tax equity partnership.
ERISA applies a “look-through” test to determine whether each entity in the structure includes plan assets subject to ERISA.
If benefit plan investors hold at least 25% of any class of equity in any entity down the ownership chain, then the assets of that tier entity are deemed to be plan assets and the ERISA rules will apply, unless another exemption applies.
If an upper-tier entity — for example, the upper-tier partnership between the developer and benefit plan — is deemed to hold plan assets under the 25% test, then the proportionate share of investment held by the benefit plan in the next lower entity is tested to determine whether the investment by the benefit plan is at least 25% in that next tier down. This is tested by multiplying the percentage interest of the benefit plan in the upper-tier partnership by the percentage interest of the upper-tier partnership in the tax equity partnership. If the interest of the benefit plan in the tax equity partnership is less than 25%, then there is no need to keep testing down the ownership chain.
If the project is a plan asset, then the ERISA restrictions on transactions with affiliates, fiduciary responsibilities, duty to disclose fees and other obligations could fall on all three entities in the ownership chain.
The project company might have a harder time entering into contracts with affiliates of the sponsor.
The key to avoid having the project turn into a plan asset and, therefore, to avoid any of these issues is to structure the transaction with the pension plan so that it fits into one of three exemptions: the 25% benefit plan investor exemption, a venture capital operating company exemption or a real estate operation company exemption. The last two are called the VCOC and REOC exemptions. There are other exemptions, but these are the most commonly used.
25% Benefit Plan Investor
The first exemption applies if the investment by pension plan investors is limited to less than 25% of each class of equity interest in the entity being tested. If benefit plan investors hold less than 25% of every class of equity in the entity, then the entity will not be considered to hold plan assets subject to ERISA.
For purposes of calculating the 25% limit, any equity interests held by government pension plans, church plans and non-US pensions are excluded from the numerator but are included in the denominator. As a result, this exemption works well where one or more non-US pension plans and US public pension plans, such as CalPERs, invest alongside a private pension plan.
The 25% limit must be re-measured each time someone acquires a new interest or increases its interest in the entity.
In addition, when calculating the 25% limit, interests held by the project developer and its affiliates must generally be excluded from both the numerator and denominator of the test.
Going back to application of the 25% test, if a benefit plan investor owns at least 25% of the upper-tier partnership with the developer, then the benefit plan investor has a large enough interest in the upper-tier partnership potentially to bring ERISA into play. The 25% test would then be applied to the tax equity partnership that is the next tier down. If the benefit plan investor owns at least 25% of any class of equity in it, then the tax equity partnership will also be a plan asset. For purposes of the 25% test, the benefit plan investor is treated as owning its percentage interest in the upper-tier partnership times that partnership’s percentage interest in the tax equity partnership. For example, assume the upper-tier partnership is owned 32% by the benefit plan and is not otherwise exempted under ERISA. Assume the upper-tier partnership holds 50% of a class of equity in the tax equity partnership and all other interests are owned by non-benefit plan investors. In this case, neither the tax equity partnership nor the project below it would be considered a plan asset, since only 16% of the tax equity partnership is considered owned by the benefit plan.
However, a tax equity partnership usually has a class B interest that is held entirely by the sponsor and a class A interest that is held by the tax equity investor. Thus, the upper-tier partnership between the sponsor and benefit plan is likely to own 100% of a class of equity interest: the class B interest.
Anyone relying on the 25% exemption should monitor the 25% limit on an ongoing basis, calculate the limit properly and consider the impact of investor defaults, interest transfers and restructuring into alternate vehicles.
The second exemption is the VCOC exemption. This exemption is often used when investment by private US pension funds exceeds or is at risk of exceeding the 25% limit. To qualify for the VCOC exemption, the fund must meet both an asset test and a management rights test.
The focus of the VCOC exemption is the entity in which the pension plan invests — in this case, the upper-tier partnership with the developer that holds the sponsor interest in the tax equity partnership.
To fit in the exemption, that entity must hold at least 50% of its assets valued at cost in operating companies. For this purpose, operating companies are companies that are, directly or through majority-owned subsidiaries, actively engaged in the production of goods or services.
It is not clear whether ownership of a project through the sponsor side of a tax equity partnership would be considered ownership of the project through a majority-owned subsidiary, since the sponsor starts with only a 1% interest in partnership income and losses that increases later to 95%, but it often has a majority share of the cash and day-to-day control over the business from inception.
If a benefit plan investor entity will make multiple investments, then the 50% test must be met when the first long-term investment is made. If the entity does not meet the 50% test on the date of its first long-term investment, then it will not qualify as a VCOC.
Most US pension plans investing in US renewable energy projects invest through a blocker corporation to avoid preventing the project from qualifying for an investment tax credit and accelerated depreciation. These tax benefits cannot be claimed on such a project owned partly by a government or tax-exempt entity. The tax benefits are disallowed to the extent of the tax-exempt ownership.
Use of a blocker corporation by itself does not solve the problem if government or tax-exempt entities in the United States own 50% or more of the blocker by value, as that will turn the blocker into a “tax-exempt controlled entity” with the same result. The benefit plan investor entity would have to elect out of “tax-exempt controlled entity” status, which it may be unwilling to do, because the election out requires reporting dividends and capital gains upon exit as “unrelated business taxable income” on which any non-government pension plan would have to pay income taxes.
In cases where a blocker is used, the tests are applied at the blocker level if the blocker has multiple US private pension plans as owners. (Public plans and foreign plans are included in the denominator but not the numerator.) An example is where several pension plans invest through a jointly owned blocker. The 25% test is applied first at that level and, if it is a problem, then the blocker must be a VCOC (or qualify for another exemption).
The other VCOC test is a management rights test. To qualify for the VCOC exemption, the pension plan must obtain direct contractual management rights in the underlying qualifying operating company and must actually exercise those rights in the ordinary course with respect to at least one qualifying operating company each year.
In the case of a jointly owned blocker corporation plus three tiers of entities, these contractual rights would have to run between the blocker corporation and project company. The entity seeking to have VCOC status would have to have direct contractual rights in an operating company and generally cannot have these rights through intermediate entities unless the entity seeking to have VCOC status owns a majority interest in the intermediate entity and each underlying subsidiary.
A problem exists if the interest in the project company is held by an intermediate entity that holds a minority interest in the project company. In that case, the project company generally would not be a valid VCOC investment. This problem may be solved by having the entity seeking VCOC status own 100% of the intermediate holding company.
Thus, the management rights must be direct contractual rights between the benefit plan investor entity and the operating company giving the benefit plan investor entity the ability to influence or have a substantial say in management of the operating company.
The right to appoint an operating company board member with full voting rights is generally sufficient for this purpose.
In addition, the US Department of Labor has advised that the following rights will be considered sufficient management rights for purposes of the VCOC test: the right to meet periodically with management, appoint company officers, appoint board or management observers, advise and consult regarding the conduct of business, examine the operating company’s books and records and receive periodic operating company financial statements.
The benefit plan investor entity need only possess some of the rights. It is not necessary to have all of them, although in practice, the benefit plan investor entities typically request management rights side letters that include each of the rights.
To qualify for VCOC status, the benefit plan investor entity must have its own direct contractual rights. For this purpose, rights shared with other investors or co-investors will not qualify. Rights set out in the operating company agreement generally will not qualify unless the rights are specifically designated as rights of the particular benefit plan investor entity.
As a result, entities seeking to establish or maintain VCOC status typically ask each portfolio company to enter into a separate “management rights side letter” conferring direct management rights upon the blocker corporation. The management rights side letter usually includes the list of management rights listed earlier.
The third exemption is the REOC exemption. This exemption is more common to find used in real estate investments.
It is similar to the VCOC exemption, except that the nature of the investments is different. To qualify as a real estate investment, the REOC must have rights to participate directly in the management or development of the underlying real estate, and must actually exercise the management rights in at least one investment each year.
Since the real estate investment must be actively managed, fallow land and triple-net-lease assets typically do not qualify as REOC investments.
There is not a lot of guidance about whether specific infrastructure investments, such as power plants, are considered real estate for purposes of the REOC exemption.