A short primer to side letters and their many intricacies
Perhaps not as well-known as other contracts within private equity, side letters nonetheless serve a vital function for private equity funds by allowing investors to negotiate for individualized terms with a fund’s sponsor, instead of having to rely solely on the contents of the fund’s constitutional documents. In theory, side letters are a prime example of the efficiency and flexibility created by so-called contract modularity, whereby larger wholes are broken down into smaller, more manageable pieces allowing for a more focused and individualized negotiation process. They are also well suited for attending to bespoke requirements for certain groups of investors, such as specific regulatory- or tax requirements.
Side letters may seem harmless in many instances, but the practice of providing side letters risk turning into a situation whereby select investors are awarded beneficial treatment to the detriment of others, such as preferential redemption- or information rights, potentially giving such investors an advantage over other investors in the same fund. Side letters grow even more precarious given their secrecy, as their existence and contents are rarely voluntarily disclosed, resulting in many investors not necessarily being aware of any side letters that might affect their investment negatively.
The very structure of side letters makes them susceptible to a plethora of risks and inefficiencies, both formal, such as uncertainties regarding their validity, interpretation, and enforcement, as well as informal, such as ballooning administrative burdens or severe cost inefficiencies. Many of these obstacles are the result of information asymmetry and imbalances in negotiation-power between the parties, and a set of fairly unique misaligned incentives seemingly upholding the current market practice.
Although the governance structure of private equity itself give rise to some of these inefficiencies, it may also pose an optimal setting for addressing these very issues, as the parties to a side letter usually are some of the most sophisticated when it comes to financial- and legal innovation and pioneering. Sponsors and investors alike stand to gain from successfully addressing any such obstacles.
Methodology and approach
My thesis sought to not only provide a better understanding of what side letters actually are and what they normally contain, but to go one step further by mapping the potential causes of the potential obstacles highlighted above and providing a rationale as to why they seemingly continue to persist. This holistic approach to the framework surrounding side letters made attempting to suggest some first steps in tackling such potential obstacles much easier. The thesis being legal in nature, applicable legislation and legal theories constitute the starting point, but as more empirically focused studies on side letters are rapidly starting to emerge in the space, also concrete, real-world data could be utilized to put said theories to the test, and provided a valuable indicator as to which issues are most likely the biggest obstacles in practice [1]. Proactive Law, largely pioneered by Nordic legal researchers, was then applied to the identified inefficiencies to arrive at suggestions for corrective actions.
Main findings
Many of the formal, legal problems with side letters are seemingly exceptions rather than the norm, and can be addressed with careful drafting, avoiding certain terms, as well as sufficient investor disclosures. The more complex issue instead seems to stem from the more informal inefficiencies, resulting in additional costs, time, and resources spent on creating and upholding side letters.
One such source of inefficiencies is the Most Favored Nations-clause, or MFN – a contractual term whereby an investor is given the right to review and select amongst terms given to other investors, giving them an opportunity to choose more favorable terms. It is one of the most frequent and negotiated terms in a side letter, and results in an ever-growing web of complex interconnections between investors and their side letters. Other factors include over-modularity, caused by multiple versions of both bespoke and substantially the same terms being negotiated simultaneously with several different investors, and unnecessary use of boilerplate provisions that could instead have been included solely in other agreements. This results in a considerable burden for sponsors to negotiate, maintain and adhere to all applicable side letters simultaneously, and a potential opportunity cost by decreasing time available to manage the fund and generate returns.
The persistence of this suboptimal structure can be accredited to a large number of misaligned incentives, discouraging both sponsors and investors from taking active steps to correct it. On the one hand, the recent sponsor-friendly market has moved the starting point of negotiations towards favoring sponsors, and they often bear only a small part of their negotiation costs, as well as having several psychological biases working in their favor, such as anchoring, the status quo effect, path dependency, and herd behavior. On the other hand, investors suffer from a classic example of prisoner’s dilemma causing them to shy away from collective negotiations, as big investors are usually better off focusing their negotiation power on individual negotiations.
The thesis finally arrives at some suggestions for steps that can be taken in order to improve side letters and the problem they set out to solve. In addition to making side letters shorter, simpler, and more straightforward, the real value lies within embracing the law and side letters themselves as tools to achieve business goals and increase value. By embracing the idea of using the law as a source of competitive advantage, many of the risks and inefficiencies highlighted here can not only be mitigated, but also provide concrete advantages for the first movers in the sector. Seeing the law as merely a source of compliance costs is unlikely to lead to any meaningful change in the side letter practice.
Recent developments in the U.S.
In August of 2023, the U.S. SEC published the final text on the proposed rules, marking an important milestone in the active debate regarding preferential treatment of investors in recent years. Under the new rule, side letters may only be offered alongside rigorous disclosures to investors or even potential investors. Additionally, all preferential treatment concerning redemption and portfolio holding information will no longer be allowed, to the extent such preferential treatment would have a material negative effect on other investors. These new rules will have to be complied with in the U.S. by 14 September 2024 or 14 March 2025, depending on the size of the sponsor, and is likely to lead to lots of activity within the area this year.
The proposed rules share many similarities with the already existing rules within the EU, focusing on outright prohibition of certain terms, and requiring substantial disclosure in other cases. Based on the findings in my thesis, however, it is unclear as to whether such a compliance-focused view on the practice of providing side letters really is the best way to go, or whether the new rules will simply be seen as a mandatory obstacle and a source of costs by many. Any such prohibitions and disclosure requirements do little to address the informal inefficiencies seemingly causing the most issues currently. It remains to be seen how market actors will embrace these new rules and in which direction the market starts to shift, if at all.
The thesis is available at https://helda.helsinki.fi/items/30565ebe-4e8f-4c76-bb1d-90cde3c18157.
References
[1] Some studies on side letters with an empirical element featured in the thesis are:
De Fontenay, Elisabeth – Nili, Yaron. Side Letter Governance. European Corporate Governance Institute – Law Working Paper No. 710/2023.
Jeffers, Jessica S. – Tucker, Anne M. Shadow Contracts. The University of Chicago Business Law Review, Vol. 1, No. 1, 2022.
Simmons & Simmons LLP. Hedge Fund Side Letter Survey 2022.
Seward & Kissel 2022 LLP. 2022/2023 Hedge Fund Side Letter Study.
