The side letter arms race
Critics of side letters say they perpetuate inequalities among investors; supporters claim they are just an efficient means of price discrimination. What’s the truth? A new academic study attempts to answer the question once and for all.
Side letters have proliferated over the past decade or so. It’s perhaps unsurprising, therefore, that they have attracted high-profile criticism for favouring large investors at the expense of smaller ones. But their proponents say they are just a means to charge different prices to different investors based on willingness to pay, much as happens in other industries. They have also attracted the US Securities and Exchange Commission’s attention: it has adopted new rules that prohibit preferential treatment that could have a negative effect on other investors and that require GPs to disclose differential terms contained in side letters to all investors.
Yet, in one of the first empirical, academic studies of side letters, two law professors find that neither side has the story correct. In an interview with Elisabeth de Fontenay, one of the academics, we explore what’s actually contained in these documents, who really benefits and what’s needed to stem the tide of document overload.
Elisabeth de Fontenay’s primary research interests are in the fields of corporate law and corporate finance. She is a professor at Duke University School of Law, which she joined in 2013 after serving as a Climenko Fellow and lecturer at Harvard Law School.
Elisabeth de Fontenay
Why are side letters attracting such negative attention?
“Criticism has primarily focused on the idea that investors in private funds are treated very differently as a result of side letters: that the biggest investors receive highly preferential terms and that the smaller ones aren’t even aware when this happens. That is a bridge to the second point of controversy. Side letters are one of the more salient examples of pervasive secrecy in the private equity industry. They are not disclosed publicly, but they are also not disclosed to other investors in the fund. This is considered emblematic of the desire by sponsors, and in particular their lawyers, to keep PE documentation confidential.”
Where is this criticism coming from?
“Some of it comes from investors themselves. Side letters are complex and costly, and investors can feel they are signing on to something without really knowing what the terms are. There has also been criticism from outside observers. In particular, US senator Elizabeth Warren had proposed federal legislation that would ban side letters entirely – although this didn’t happen.”
Based on your research, are these concerns valid?
“I would say that the idea that side letters are perpetuating inequality among investors is misplaced. The primary way in which they are treated differently within individual PE funds is through co-investment. These arrangements typically take place outside of the side letter process with a wink and a nod.”
Are there negative impacts to side letters that don’t get the recognition they deserve?
“There are valid concerns around the wildly inefficient and costly process of negotiating side letters. It really pushes up the expense of setting up funds. Perhaps more importantly, however, it imposes constraints on the funds themselves. If a sponsor agrees with one limited partner not to invest in a particular industry or a particular structure, that has direct implications for other investors. It is a constraint on the manager’s ability to exercise discretion, and it may not be optimal to the fund as a whole.”
Is there any value to what side letters provide?
“The original impetus for side letters was the need to address individual investors’ specific regulatory and tax concerns. The real question is whether these issues need to be addressed in side letters. To a large extent, sponsors could easily facilitate this using additional forms or information for tax purposes.”
Can these issues be addressed through the better use of regulation?
“Almost certainly, the best use of regulation is ensuring that contractual provisions, whether in the main contract or side letters, are actually enforced. Ever since the Securities and Exchange Commission gained the right to inspect funds under the Dodd-Frank Act in 2013, it has identified major instances of sponsors not abiding by contractual arrangements, including taking compensation that investors weren’t aware they had agreed to. Concentrating on enforcement is a better approach than trying to prescribe terms.
“Standardising forms is another area where the market could improve significantly. A huge amount of money is spent drafting contracts and negotiating terms, when in reality, there is an extraordinary amount of duplication. There is no reason why there couldn’t be a completely standardised limited partnership agreement and a completely standardised side letter, if indeed a side letter is even required.”
“We have seen similar moves with derivatives, where the market itself took control of the process. Similarly, with venture capital, the National Venture Capital Association [in the US] has standardised the contract between funds and founders. Market participants took the lead, and that has been wildly influential, resulting in substantial cost savings for all of those involved and network efficiency, with everyone working from the same documentation and aware of what the major negotiation points are. We just don’t have that with PE funds.”
Is there potentially a role for technology in streamlining negotiations between LPs and GPs?
“I certainly wouldn’t resist the use of artificial intelligence (AI) in this space. I have seen examples of promising products that could help with the drafting process. Nonetheless, the larger point remains. If you allow for a complex system of individual negotiations between sponsors and LPs, then you will end up with a highly complex contractual framework that is almost certainly unnecessary.
“It would be great if those contracts were drafted by AI rather than by lawyers. But you would still need a lot of lawyers signing off on those agreements. It would still be an inefficient process and you would still be left with a fund that now has to comply with all of these different documents.”
How open do you believe the different constituent groups are to addressing these issues?
“Both GPs and LPs are expressing unhappiness with the situation. The problem is that there needs to be collective action, with some centralising force or institution coordinating everyone to move towards a different equilibrium. The biggest barrier, meanwhile, is almost certainty the lawyers. They have no incentive to make this process more efficient and are themselves the primary drivers of secrecy in the industry.
“There is no reason for these documents to stay secret. It is more about lawyers wanting to attract clients based on the terms they can negotiate. Lawyers are therefore reluctant to engage with their competitors and agree on standard forms and language for what we know are the same provisions being negotiated over and over again.
“At the same time, once you allow for side letters, individual LPs have no incentive not to ask for them, and so there is a ratcheting effect, where LPs ask for more and more provisions, even though those provisions aren’t particularly substantive. That is why we have seen this huge increase in the complexity and length of side letters over the years.”
Side Letter Governance, by Elisabeth de Fontenay (Duke University School of Law) and Yaron Nili (University of Wisconsin-Madison Law Schoo...