What is ERISA?
ERISA is the Employee Retirement Income Security Act of 1974, which governs, among other things, the investment of certain benefit plans into hedge funds. The significance of ERISA for hedge funds is that if more than 25% of a hedge fund’s equity interests are those of certain “benefit plan investors,” all of the hedge fund’s assets will be considered “plan assets” under ERISA and Section 4975 of the Internal Revenue Code of 1986, and will thus be subject to a multitude of regulations, including, but not limited to:
- The hedge fund’s manager will be a fiduciary of each benefit plan investor governed by ERISA, making fund managers and plan trustees liable for each other’s actions, and the manager’s activities will be subject to ERISA’s general fiduciary requirements;
- All of the hedge fund’s activities will be subject to the prohibited transaction rules under ERISA and the Internal Revenue Code, which may have the effect of restricting transactions with affiliates, and will require that all performance fees be structured to ensure compliance with applicable Department of Labor guidelines; and
- In many instances, failure to comply with the 25% limit will result in a withdrawal or redemption of the capital committed by ERISA benefit plans.
Which Benefit Plan Investors Matter For Purposes of ERISA?
The term “benefit plan investor” is defined broadly as:
- Any employee benefit plan, whether or not subject to ERISA and whether or not covering U.S. employees;
- Any plan described in Section 4975(e)(1) of the Internal Revenue Code, which includes IRAs and Keogh plans; and
- Any entity whose underlying assets include “plan assets” by reason of an employee benefit plan’s investment in the entity (i.e. other vehicles or funds that do not comply with the 25% limit).
It is important to note that the term “benefit plan investor” includes plans that alone are not subject to ERISA.
Calculating the 25% Limit
Contributions made by managers and their affiliates:
In calculating the 25% limit for a hedge fund, the value of any equity interest held by the following persons is disregarded:
- Any person who has discretionary authority or control with respect to the assets of the hedge fund (i.e. the general partner or managing member);
- Any person who provides investment advice for a fee (direct or indirect) with respect to such assets (i.e. the investment manager); or
- Any “affiliate” of the above. An affiliate of a person includes any person, directly or indirectly, through one or more intermediaries, controlling, controlled by, or under common control with the person.
Classes of interests:
The 25% limit must also be satisfied separately with respect to each “class” of interests issued by a hedge fund. If one class of interests does not satisfy the 25% limit, the assets of the entire hedge fund are considered to not satisfy the 25% limit.
For the purposes of a master-feeder fund, the 25% limit is calculated for each fund in the structure.
A note on IRA investors
Individual Retirement Accounts (IRAs) are considered benefit plan money, but are not covered under ERISA as long as there are no other funds in the class that are considered ERISA funds. However, once other funds are accepted that are subject to ERISA, the IRA funds count towards the 25% limit.
Monitoring the 25% Limit
A hedge fund that accepts contributions by benefit plan investors and that intend to comply with the 25% limit must have procedures in place to monitor the percentage interest held by such benefit plan investors. Compliance usually entails having a purchaser represent whether it is a benefit plan investor, and keeping track of all subscriptions, redemptions, or transfers of interest made by benefit plan investors in the hedge fund. Purchasers must also notify the hedge fund if its status as a benefit plan investor changes.
In light of the regulatory requirements under ERISA, fund manager should carefully consider whether or not to accept capital contributions by benefit plan investors. If such capital contributions are accepted, hedge fund managers should take steps to ensure that the hedge fund will abide by the 25% limit.
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