Equity Knowledge Series
The Problem with Side Letters in Private Equity
Side letters - expanding in size and scope – are becoming a management (and cost) headache for private equity sponsors.
Jan 30, 2023
Common Side Letter Clauses
Growth of Side Letters
Since private equity funds emerged in the late 1980’s, limited partners (LPs) have requested side letters to secure special rights not granted in the limited partnership agreement (LPA) that applies to all fund investors. The provisions in a side letter can supplant terms in an LPA or address new issues absent from it.
Though not a recent innovation, side letters have lately expanded across a number of dimensions. As a result, orchestrating the many exemptions, immunities, and preferences conferred by side letters has come to represent a growing burden for fund sponsors. The resources consumed form a cost center that detracts from fund returns, as well as general partner (GP) attention that could instead be devoted to core business activities like deal sourcing and facilitating growth at portfolio companies. Rather than buttress the LPA, side letters have instead tended to ensnarl and overwhelm the document with exceptions.
After listing some of the most common accommodations sought by investors, this paper will attempt to describe the complexity of side letter management and its wider impact on fund operations. In addition to factors inherent to side letters, the paper examines external matters, including co-investing vehicles and looming SEC regulation, which compound the contract management and compliance strains bearing down on sponsors.
Common Side Letter Clauses
Although side letters are widely viewed as a means to accord fee discounts to favored investors, they are “mostly designed to accommodate a fund investor’s regulatory and tax concerns” [Footnote 1]. Pension plans and sovereign wealth funds in particular use side letters to ensure that an investment does not violate their governing statutes or negate sovereign rights conferred by their government status. Side letter clauses with regulatory implications include ones that allow investors to:
Avoid participating in deals involving certain industries (e.g., alcohol and tobacco)
Obtain specialized reporting or disclosure information, which allows the investor to satisfy reporting obligations imposed by its stakeholders (e.g., a public section pension fund obtains permission to share a fund’s prospectus with the fund’s government stakeholders.)
Secure guarantees of confidentiality regarding the investor’s position in the fund
Designate the place of jurisdiction for any litigation
Gain the right to transfer its holdings to another entity
Investors also pursue side letters for non-regulatory reasons. They may want to secure seats on the advisory committee of fund investors, register their interest in co-investing opportunities that arise during the lifecycle of the fund, or receive a guarantee - through a most favored nation (MFN) provision - that they can obtain any favorable preference furnished to other investors in their separate side letters. Some investors, especially those considered “strategic”, such as seed investors or ones that have made especially large commitments, seek out fee discounts.
Although this paper focuses on the problems associated with side letters, the positive role they play in the corporate finance ecosystem should also be acknowledged. By catering to the needs of institutional investors and allowing them to deploy capital in accordance with their by-laws, side letters have given borrowing enterprises access to large-scale financing that might otherwise have been difficult to secure.
Growth of Side Letters
In a recent academic paper, Elisabeth de Fontenay (Duke University School of Law) and Yaron Nili (University of Wisconsin Law School) describe the results of their longitudinal study of side letter provisions. From a data set of roughly 250 side letters issued between 1991 and 2020, they track five indicators of length and complexity (total terms; word count, page count, provision count, and total MFN exceptions). As they show, each of these indicators has exhibited uninterrupted growth since the start of the study period. In documenting the evolution of two of these measures, they note:
The average length of side letters has increased more than sevenfold over the last 30 years with an average word count of 659 words in the pre-2005 era and 4,983 words in the post-crisis [after 2014] era. The page-length of each side letter has similarly ballooned from an average of 1.3 pages in the pre-2005 era to 8.5 pages in the post-crisis era.
Although no formal study has captured the change empirically, it is generally acknowledged that a greater percentage of LP’s now seek to negotiate side letters. Whereas side letters were mostly the preserve of strategic investors in the early days of private equity, they are now common among a broader swath of investors.
Side letters have also come to address a greater range of issues, increasing the complexity of negotiations and the travail of ongoing oversight. The increased scope is perhaps most visible in regards to ESG provisions. LPs – each subject to different jurisdictions and representing unique sets of stakeholders – will come to the table with a unique bundle of ESG investing mandates. Because ESG provisions are rarely addressed in the LPAs of non-impact funds, side letters must shoulder the contractual responsibility of catering to these mandates. In addition to excusal rights that allow an LP to withdraw from participating in investments in certain industries, sponsors may also be required to produce periodic reporting that demonstrates adherence to third-party guidelines, including multilateral initiatives such as the Principles of Responsible Investment and the UN Global Compact.
More broadly, side letters have come under the spotlight by virtue of the marked growth in private equity volumes. Total global buyout volume reached $1.12 trillion in 2021, an all-time high that roughly doubled 2020’s total ($557 billion) and that represents a 9.5X on the post-global financial crisis low recorded in 2009 ($118 billion) [Footnote 2]. Buyout funds are inhabiting new niches such as infrastructure and technology and taking on more substantial deals, with the average transaction size for 2021 exceeding $1 billion for the first time [Footnote 3]. The quanta of outstanding side letters has risen accordingly alongside the important role they play in what has become a rapidly growing and important source of capital for business of all sizes and sectors in economies around the world.
On a strict contractual basis, side letters just treat the bilateral relationship between two signatories. Despite the limited number of parties, side letters invariably generate wider impact across several areas.
The Cascading Burdens of MFN Clauses
Fulfilling the terms of one side letter can force additional work on the sponsor to comply with other letters that contain an MFN clause.Although each side letter represents a separate contract, in practice, substantial interdependencies exist. Sponsors do not therefore have the luxury of managing side letters in isolation from one another. As MFN remains one of the most frequently sought preferences, sponsors must then consider side letters on both an individual and group basis.
Borrowing Base Impact
Side letters can impact a fund’s borrowing base. Funds often take out bridge loans from banks for immediate financing needs while a capital call is underway from investors. These loans are secured by terms in the LPA that obligate LPs to fulfill all capital calls. Bank lenders therefore scrutinize side letters to ensure that provisions in the letters do not temper this obligation. A bank may reduce a fund’s capacity to borrow if terms, especially those related to excusal and transfer rights, compromise the binding nature of an LP’s commitment.
Effect on Fund Strategy
A fund sponsor may forego promising investment opportunities that conflict with the preferences of major investors that retain excusal rights, especially if the fund would lack sufficient capital for the deals absent those investors. Other investors without the same concerns would then miss out on these foregone deals. The idiosyncratic preferences of some investors could therefore impact the fund’s strategy, its portfolio composition, and the returns for all investors.
Transaction Costs & Risks
As a result of all these primary and knock-on effects, fund managers are forced to devote significant resources to negotiating side letters at the outset of a fund and to ensuring compliance with them on an ongoing basis after launch. As even the Institutional Limited Partners Association admits: “The cost of negotiating and complying with side letters can be sizable." [Footnote 4]
In more detail, de Fontenay and Nili argue:
Side letters are costly to the industry. Not only do they burden the fund-raising process for buyout funds with ever-increasing delays and legal fees, they also create a highly complex web of contractual arrangements for a fund to comply with, which can restrict the fund’s operations and investments in a variety of unexpected ways—an outcome that harms both sponsors and investors. [Footnote 5]
The authors point out that for all the effort they require, even the most exquisitely designed side letters fail to contribute to activities that drive fund performance. Detached from deal acquisition costs and focused on accommodating investor preferences, side letters hamstring funds with an ongoing drag of administrative expense.
Another recent study by a different set of authors that focuses on side letters in the context of impact investing builds on these conclusions:
Complex terms with layers of carve-outs, developed across multiple documents increase compliance costs over the life of the fund. ... Without limits on side letter provisions or a checklist to monitor performance of all fund side letter agreements, managers can be swamped by compliance obligations. The combination of complexity and divergence presents general partners with a business risk in complying with the stipulations of one side letter without falling afoul of another or of the LPA itself. [Footnote 6]
On top of the aforementioned concerns looms the issue of increased regulation. The SEC has released a number of proposals over the past year that, if enacted, would directly affect the crafting and ongoing management of side letters. Specifically, the SEC has proposed the following:
No liquidity preference may be given to any investor, even with disclosure
No information, especially concerning portfolio holdings, may be provided to any investor when withholding it from other investors could have a “material, negative effect” on the latter
Any other preferential treatment must be disclosed to all prospective investors when considering a placement, and to current investors on an ongoing basis through annual written notices
While eliminating some terms reduces complexity, persistent disclosure adds considerable work. More significantly, in future examinations of fund advisers, it is likely the SEC would place side letters under a microscope, thereby sharpening the need for fund managers to maintain rigorous oversight. The compliance risks would multiply even as the number of possible terms included in the side letter falls.
Side letter expansion has coincided with growth in side-car and co-investing vehicles. According to the World Economic Forum, the share of private equity investors that utilize co-investing has nearly tripled from 24% in 2012 to 71% in 2021 [Footnote 7]. The US-based asset manager Hamilton Lane has also estimated that “for every dollar raised by a GP, an additional twenty cents is allocated to deploy in global co-investment opportunities". [Footnote 8]
Co-investments, however, bear their own set of terms that can affect the primary LPA as well as side letters. A number of thorny issues in particular arise in connection with stockholder rights. In an article on structuring co-investment transactions, James J. Greenberger notes:
The co-investment vehicle, the sponsor's fund, the management stockholders, and the other co-investors are all parties to a stockholder's agreement, which typically contains provisions governing such issues as tag-along rights, drag-along obligations, information rights, preemptive rights, registration rights, and supermajority consent rights among the various investors in the holding company. [Footnote 9]
The trade-offs associated with different approaches to handling these topics lies beyond the scope of this paper. Needless to say, ensuring that these rights are construed so that neither co-investors nor primary fund investors with their accompanying trail of side letters receive favorable (or derogatory) treatment requires active consideration during both the fund and co-vehicle formation processes.
In addition to stockholder rights, the existence of co-investing funds generates additional issues related to disclosure, fee allocation, and apportioning of deal shares across separate vehicles. Managing liquidity events when investors in one particular vehicle wish to retain their position can also pose complications if sponsors are required to carry out uniform liquidity actions for all entities due to provisions in founding documents intended to ensure fair and equal treatment.
The complications generated by side letters show little sign of abating. Both the size of the private equity market and the number of active investors in the class have tripled over the last decade10. As the best performing segment within private markets in recent years11, private equity is poised to attract additional capital and expand further. This growth will bring with it new investors and new investor types, each with the potential to advance a particular assortment of preferences that funds have not previously been asked to accommodate.
On the regulatory front, regardless of the final form proposed SEC reforms take, the transition to a more stringent regime will likely be arduous as GPs and LPs alike work to interpret the intent and import of each new rule and adjust their approach to side letters accordingly. Separately, in many jurisdictions, new ESG concerns will continue to get enshrined into laws, industry standards, and eventually more rigorous investment mandates. Negotiations over side letters will need to reconcile these burgeoning concerns with a fund’s overall strategy and operations.
Individual GPs, though seldom able to resist the full panoply of investor demands, can still take advantage of platforms such as CredCore that simplify side letter management. Several marquee private equity firms deploy CredCore’s to integrate their side letters onto a common digital platform. Fund managers can then view like provisions from across different side letters and evaluate interdependencies that ensue from MFN provisions. For a demo of these and other features, please contact firstname.lastname@example.org.
Elisabeth de Fontenay and Yaron Nili. Side Letter Governance. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4067905
Bain & Company. The Private Equity Market in 2021: The Allure of Growth. March 7, 2022. https://www.bain.com/insights/private-equity-market-in-2021-global-private-equity-report-2022/
Institutional Limited Partners Association. ILPA Principles 3.0. 2019. https://ilpa.org/wp-content/uploads/2019/06/ILPA-Principles-3.0_2019.pdf
de Fontenay and Nili.
Jessica Jeffers and Anne Tucker. Shadow Contracts. University of Chicago Business Law Review. Spring 2022. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4094306
World Economic Forum. 3 Tips from Trillion-Dollar Investors on Sealing the Co-Investment Deal. August 21, 2022. https://www.weforum.org/agenda/2022/08/3-tips-from-trillion-dollar-investors-on-how-to-seal-the-co-investing-deal/
Jeffrey Armbrister. Co-Investing: The Struggle is Real. Hamilton Lane Insights. June 20, 2019. https://www.hamiltonlane.com/en-US/Insight/Co-Investing-Struggle
James J. Greenberger. Private Equity Co-Investment Strategies: Issues and Concerns in Structuring Co-Investment Transactions. The Journal of Private Equity. Page 56. Vol. 10, No. 4 (Fall 2007). https://www.jstor.org/stable/43503531
Blackrock 2022 Private Markets Outlook. https://www.blackrock.com/sg/en/institutional-investors/insights/2022-private-markets-outlook
McKinsey Global Private Markets Review. March 24, 2022. https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review