What is the Deal with…Side Letters?

In February 2022 the Securities and Exchange Commission (SEC) released proposed rules that could significantly impact reporting and compliance obligations for private funds. The proposed changes include restrictions for private fund managers on the common practice of entering into side letters with investors. This publication follows an editorial previously issued which lays out all proposed rules and the potential impact on private funds and their stakeholders.

What is a side letter?

Side letters are tools utilized by private fund managers to grant special rights and privileges, often to key or significant investors and to those limited partners (LPs) subject to government regulations. These letters lay out terms that supplement or alter the terms of the primary governing fund agreement (often a limited partnership agreement) and are formalized in a letter executed by a fund manager and acknowledged by the LPs in question. Side letters can also be utilized by private fund managers to accommodate last-minute requests from potential LPs very near to an initial or subsequent fund closing. While the use of side letters provides both investment managers and certain investors with the optionality often desired in a private investment arrangement, not everyone is happy with their current use and prevalence.

What is prohibited under the proposed rules?

The proposed rules would prohibit side letters allowing preferential treatment that could negatively affect other investors, such as:

1. Preferential redemptions.
2. Providing selective information about the portfolio holdings or exposures of the private fund or a similar pool of assets.
3. Other preferential treatment such as “excuse rights,” which allow certain investors to refrain from participating in certain investments.

In addition, the proposed rules call for advisers to disclose side letters to all investors by providing redacted copies or a written summary and description of the preferential terms provided to other investors in the same private fund.

So, what are market participants saying about the proposed SEC rules which would limit the use of these side letter arrangements?

The case for the proposed rules

SEC Commissioner Gary Gensler has called for more transparency around the use of side letters in private investment funds. A fund adviser and certain investors may agree to terms that differ from those contained in the overall fund operating agreement; side letters provide investors with those negotiated terms. Examiners noted that side letters have been used to give preferential fees and/or liquidity terms or disclosures to certain investors, putting others at a relative disadvantage. Creating favorable terms for some investors directly contradicts the idea that all investors should be or are treated equally by a fund adviser.

Several individuals and small business owners participating in the proposal’s comments process were supportive of the proposed rules around side letters. One commenter noted, a common sentiment shared by supporters during the comments process, that the increased transparency and restrictions around the use of side letters would prevent private funds from using their existing market power to force investors without side letters to surrender their rights to clear information, or to force them into deals and arrangements with more favorable terms for the private equity firm.

Another individual market participant noted that while they agreed that the new rules would promote more transparency in this field, a consequence could be significantly increased compliance costs which could reduce competition. Restrictions on the use of side letters, however, would enhance transparency and could help address outright abuses such as treating some investors differently without proper disclosure.

Several investor advocacy groups commenting on the proposed rule changes were supportive of the measures aimed at curtailing side letters, but some pushed for materiality considerations when it comes to the ultimate application, with one noting that their members believe this proposed rule should not be interpreted to require the disclosure of non-material details regarding side letters, as this could discourage managers from entering arrangements that investors deem beneficial. They went on to note there are concerns that the SEC’s proposal as currently constructed unnecessarily introduces regulatory compliance uncertainty and liability risk.

The case against the proposed rules

While the proposed rules and restrictions around the use of side letters would help increase transparency and level the playing field for all LPs, private fund managers and large institutional investors view side letters as a critical means for market innovation.

A large pension investor noted in their comments that the nature of these proposals interferes with the freedom to negotiate contractual terms between market participants and may lead to unintended consequences that are detrimental to investor. It is important to note that fair treatment of all investors does not necessarily mean identical or equal treatment of all investors. Efforts to treat all investors the same may in fact end up being unfair to some investors, could limit investor choice or investment opportunities and could cause some investors to not be able to comply with their own fiduciary, legal or regulatory obligations which are at least in part satisfied through negotiated contractual arrangements with advisers. If large investors cannot obtain the bespoke transparency, fees, or other contractual terms they require through pooled vehicles, this could lead to an increase in the use of separately managed accounts (SMAs) which would present challenges to smaller investors who are unable to invest in sizes large enough to justify an SMA relationship. At the end of the day, private investment funds are formed as their name suggests, through private contractual arrangements among market participants. The SEC, however, is not only concerned with the interests of influential parties (fund managers and large institutional investors) in these arrangements, but all market participants, including smaller-stake LPs.

One of the largest pension systems in the country noted during the comments process that side letters are a crucial means for market innovation. Investors, they purported, have limited tools to advance market practices and these side letters are one of the most important available. Side letters are often procured to require general partners to report on talent management policies and practices pertaining to inclusion, diversity, equity as well as how they identify and integrate environmental, social, and governance factors (ESG) in an investment mandate. Side letters do not prescribe practices, but rather prompt reporting to evaluate a manager’s practices and investment process. Although the proposed rules intention might enable broader participation by limited partners in any terms contained within side letters, placing restrictions on side letters could make private fund advisers more reluctant to agree to any separate terms outside of a fund’s standard governing document.

A private fund manager commenting on the proposed rules noted that side letters are sometimes negotiated between firms and investors in order to attract the kind of diverse set of investors needed to support a venture capital fund. These practices are generally well understood in the industry and many market participants feel already treated appropriately. Further requirements regarding disclosures or regulatory reporting could further impose a burden on managers and risk the ability to attract the investors necessary to raise viable funds. Concerns were also noted as to the impact of the SEC’s proposed changes around preferential treatment prohibitions on redemption rights, specifically with respect to specialized LPs, who negotiate certain redemption rights due to legal, regulatory and/or tax considerations.

The potential negative impacts to market participants included an increase in fund organizational costs due to the operational burden of producing side letters continuously; delays and difficulties added to what can already be a complex fund closing process in dealing with multiple investors on each relevant closing date; the potential for private fund advisers to be required to share side letters with investors even in a draft form causing confusion and raising unnecessary questions; the potential for investors to discern which side letter provisions have been given to which of their fellow investors, and privacy concerns. Private fund investors historically have had a high degree of confidentiality and sensitivity to disclosing to other investors what side letter provisions they have received. There is also the possibility for earlier-closing investors to be disadvantaged relative to those participating in later closings, as early investors would only get to see certain rights agreed to by their own closing, whereas later closings investors could have access to an even larger pool of rights during the fundraising period. This may produce skewed incentives that would delay fundraising efforts and increase costs.

Conclusion

A common sentiment from those who provided comments to the SEC on the proposed rule changes is that more transparency is needed by private fund managers when it comes to these types of side letter arrangements. However, each party in these private fund arrangements has their own unique compliance responsibilities, whether to regulators or other investors as part of an investment mandate, and these side letters play an important role in ensuring proper compliance. The SEC and private investment fund market participants are on their way towards creating an improved market environment where sufficient information and data is provided to all private fund investors on a timely basis, but this needs to be done in a way which is not cost prohibitive and entry restrictive to smaller and mid-market investors and private fund managers.

For more information, contact Marcum Partner Marni Pankin at [email protected] or Marcum Director Brian Trombley at By [email protected].

Sources

• https://www.sec.gov/news/speech/gensler-ilpa-20211110
• https://www.sec.gov/comments/s7-03-22/s70322.htm
• Risk Alerts that Concern Private Funds (SEC Division of Examinations) – www.sec.gov/exams
• SEC proposed rules published by the Securities and Exchange Commission