An SEC proposal on investment funds’ “side” deals, on track to be enacted early next year, has some institutional investors worried that they’ll lose a favorite negotiating tool.
The Securities and Exchange Commission’s proposal would prohibit private investment funds from giving “side letters” to chosen investors for preferential terms on cashing out or getting information about portfolio holdings or exposures. The proposal would also ban funds from providing other preferential treatment to an investor unless it was disclosed to other investors.
It’s part of the agency’s broader push, under Biden-nominated SEC Chair Gary Gensler, to heighten oversight and transparency on private funds—an opaque part of the finance industry with over $17 trillion in assets under management.
Side agreements help private equity and hedge funds attract investors. Enacting the proposal as a rule would curtail competition among funds, according to fund representatives.
Large investors, too, have expressed concern that the proposal’s disclosure requirements would be costly for funds—and could discourage them from providing side letters to investors. Many large investors say the arrangements are needed to accommodate their particular needs and advance industry practices, including diversity efforts.
“This is a big one,” said Jennifer Choi, CEO of the Institutional Limited Partners Association, a trade group representing investors, often referred to as limited partners. “For a lot of LPs, this is really important to get right in anything that the SEC does.”
The SEC’s effort is part of a proposed rule, announced in February, to require private funds to provide more disclosures on fees and expenses. Private funds, whose investors often include state and pension plans, aren’t required to be registered as investment companies.
The SEC is concerned that side deals tilt the playing field for certain investors, even as others chipping in money to the same fund are left in the dark.
“Preferential terms do not necessarily benefit the fund or other investors that are not party to the side letter agreement and, at times, we believe these terms can have a material, negative effect on other investors,” the agency said in the proposed rule.
A final version of the rule is expected in early 2023.
As currently proposed, the rule would allow some preferential terms—such as offering an investor lower fees in exchange for a higher capital contribution—only if they are disclosed to other investors.
Other terms—including those letting one investor redeem their interest in the fund earlier, or more frequently, than other investors—are banned entirely. Preferential terms regarding information about the fund’s portfolio holdings or exposures would also be prohibited.
“If you’re giving someone else a right that they’ve decided to negotiate, it’s obviously valuable,” said Tyler Gellasch, president and CEO of the Healthy Markets Association, a nonprofit that advocates for greater transparency and reducing conflicts of interest in the capital markets and has expressed support for the rule.
“The flip side of that is not having that right is also valuable,” Gellasch said. “That may materially impact the risks and the returns of the private investment for the firms left behind.”
Large investors say their ability to negotiate side letters is critical to their ability to invest. That is, in part, because the letters are a way to secure additional protections, including getting funds to disclose information that state pension funds may need to comply with statutory requirements.
Additionally, the Los Angeles Employees Retirement Association said it uses side letters to require funds to report on diversity and environmental, social and governmental (ESG) practices, securing the right to opt out of deals that don’t meet certain standards.
ILPA is concerned that the proposal’s requirement that preferential terms be disclosed on a rolling basis would be expensive and time consuming, potentially discouraging funds from using side letters.
The organization has instead called for a Most Favored Nations or anti-discrimination provision for certain funds to disclose terms at the fund’s close. Investors should be able to elect benefits granted in side letters to other investors, ILPA said.
Hedge funds and private equity funds also have concerns.
The SEC’s proposal would advantage large, established funds, some say. Investors sometimes require preferential redemption rights as a condition of seeding a fund, they said. Unable to get those rights, small and new funds could find it hard to attract initial investors.
“The rule will restrict competition and choice by creating significant barriers to entry for smaller and emerging managers, and harm the ability of existing managers to operate,” said Jenn Han, executive vice president, chief counsel, and head of global regulatory affairs at the Managed Funds Association, a trade group for hedge funds.
“The resulting industry consolidation will lead to fewer investment opportunities and returns for investors like pensions, foundations, and endowments,” Han said.
And ambiguities in the proposed rule will foster uncertainty, some lawyers warn.
For instance, the proposed rule doesn’t have parameters to determine when a preferential term has a “material negative effect” on other investors and, as such, falls within the scope of prohibited terms, according to the law firm Schulte Roth & Zabel LLP.
“The Commission has not identified a need for a far-reaching and unclear prohibition such as this,” Schulte Roth wrote in an April comment letter.
Even though the SEC’s approach has its critics, some say it’s still time to rethink how the private fund industry uses side letters.
The letters started out with straightforward, useful tailoring to the needs of a particular investor. But they’ve ballooned in recent years to include more terms, evolving into an unwieldy “contractual morass,” Duke University School of Law professor Elisabeth de Fontenay and University of Wisconsin Law School professor Yaron Nili found in a recent study.
The study found most terms included in side letters accommodate regulatory and tax requirements. Many of the terms are largely identical, according to the authors, who suggest such provisions could be standardized across the industry.
“The main takeaway is that so much of side letter practice has become very wasteful and doesn’t seem to really benefit anyone other than the lawyers themselves,” de Fontenay said.
It’s an inefficient system rife with customized agreements that are hard for private funds to administer, Gellasch said.
“The reality is they’ve got customized deals for everybody,” Gellasch said. “They lose track.”