Side Letter Governance

Elisabeth de Fontenay is a Professor of Law at Duke University, and Yaron Nili is a Professor of Law and the Smith-Rowe Faculty Fellow in Business Law at the University of Wisconsin Law School. This post is based on their article, forthcoming in the Washington University Law Review.

It is no exaggeration to say that over its roughly forty-year history, private equity has revolutionized both corporate finance and corporate governance.  When it first arose in the 1980s, the private equity buyout represented an entirely novel approach to owning, managing, and financing companies, and its effects on both corporate behavior and the financial markets have been profound.  Today, private equity is one of the major global asset classes, and it has attracted a truly staggering amount of capital over a relatively short period of time. It has been the driver behind major changes to, and innovations in, financial contracting.  Staffed with some of the most sophisticated financiers in the world and advised by the most elite law firms, private equity sponsors innovate at a furious pace in their mergers and acquisitions (M&A), financing, fund formation, and other contracts, and are relentless in advancing their interests in the financial markets.  Understanding how private equity funds themselves are structured and incentivized is therefore crucial for understanding how the private equity industry behaves and affects global finance.

In a leveraged buyout, a private equity fund acquires a company using a high proportion of debt (“leverage”), then seeks to optimize the company’s operations, governance and strategy before eventually exiting the investment through a sale or public offering (“buyout”).  Yet private equity buyout funds are distinct not only in their investment strategy—buying and selling whole companies—but also in the formation of the funds themselves. The sponsor that sets up and manages the buyout fund enters into a long-term agreement with investors that governs the relationship among them.  This agreement, formally a limited partnership agreement (or LPA), typically bestows on all investors in the fund the same rights and obligations. Over time, however, this simple and uniform structure has become far more complex: sponsors routinely enter into separate agreements (or “side letters”) with some or all of their investors, under which each investor in question is granted a tailored set of additional rights. Depending on the fund, the terms of any given side letter need not be disclosed to the other fund investors.

This feature of the private equity industry has finally come under the spotlight and provoked greater regulatory interest,  public attention,  and investor concern,  culminating in a new and sweeping regulatory intervention. On February 9, 2022, the Securities and Exchange Commission (SEC) voted to propose new rules that, among other changes, specifically address side letters for private investment funds such as buyout funds.  The SEC’s proposed rules have already triggered what is likely to be a very long battle with fund sponsors and their counsel.  Thus far, however, neither side has mustered data to support its preferred policy approach.

Broadly speaking, side letters have elicited two opposing views among policy-makers and academics. The first views them as nakedly exploitative: by enabling sponsors to grant special (and secret) rights to favored investors, side letters put smaller, less sophisticated investors at an economic and informational disadvantage.  In this view, the fact that investors in the same fund may be treated very differently is inherently unjust.  Senator Elizabeth Warren (D-Mass.) and others have at times called for a flat prohibition on side letters for this very reason.  The most recent SEC rule proposal explicitly reflects this view, arguing that side letter terms “can have a material, negative effect on other investors.”

The second view argues that side letters—together with other tailored arrangements between private equity sponsors and specific investors, such as co-investments—are simply a form of price discrimination.  According to standard economic analysis, under some conditions a sponsor will raise the most capital and achieve the most efficient collective outcome by classifying investors according to their willingness to invest in the sponsor’s fund and charging each group a different “price” (in this case, the compensation or “fees” payable to the sponsor for managing the fund).  Rather than nefarious collusion between sponsors and the most sophisticated investors, side letters are, according to proponents, simply a rational and efficient response to the fact that private equity investors differ in their willingness to pay. In this regard, private equity would be no different than the airline and pharmaceutical industries, for example, in which different categories of consumers are routinely charged different prices.  SEC Commissioner Peirce espoused this view in her opposition to the SEC’s recent rulemaking proposal, stating that “these well-heeled, well-represented investors are able to fend for themselves.”

Yet, both views have lacked empirical support for their respective claims. This is because buyout fund agreements are not publicly disclosed and are subject to strict confidentiality requirements,  such that only sponsors, select investors, and their respective advisors have access to them. As a result, empirical analyses of side letter terms are lacking. In a new article, forthcoming in the Washington University Law Review, we provide a novel, hand-collected and hand-coded dataset of side letters, that provides much-needed insight into one of the most guarded industries in the U.S. economy and the unique contractual relationships private equity sponsors have with their investors. We assembled a unique sample of 96 limited partnership agreements and 252 side letters from a range of buyout funds, spanning thirty years.

Not only is the data that we have compiled descriptively novel, it also leads us to reject both prominent views of side letters. Before making normative claims about side letters, it is imperative to first accurately describe their content. We hand-coded the material terms of each side letter in the sample, identifying more than eighty substantively distinct side letter provisions. Our dataset paints a far different picture of side letters than do the two competing views described above. We find that side letters very rarely contain true “price” terms (such as fee discounts), and that even terms that could potentially affect the economics of an investor’s stake in the fund indirectly are relatively rare compared to other categories of side letter provisions. Instead, most side letter provisions simply seek to accommodate the investor’s regulatory and tax characteristics. The claim of both critics and proponents that side letters serve primarily to award different economics to different investors is mistaken. The true financial impact of side letter arrangements appears marginal, at best.

Although side letters have considerably less economic importance than either view would suggest, it does not follow that they are harmless. Given how little side letters actually achieve, we argue that the costs of negotiating and complying with them outweigh their collective benefits to investors and sponsors. Moreover, they point to longstanding failures of private equity sponsors to provide basic, uniform disclosure to their own investors.

Indeed, we find that side letters have grown substantially in length and complexity over time. As one example, the “most favored nation” provision—under which one investor may request the benefit of other investors’ side letter provisions—has given rise to a morass of exceptions and qualifications that only a lawyer could admire.  Side letters are therefore costly to the industry. Not only do they burden the fundraising 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. The more investors in the fund, the more one-to-one negotiations between the sponsor and individual investors will weigh on both fundraising and execution for the private equity industry.

If side letters are both costly and of limited economic importance, why do they exist? Why has the side letter process ballooned in scale and scope, despite widespread dissatisfaction from both sponsors and investors?

The culprit, we find, is a combination of investor collective action problems, sponsor and lawyer agency costs, and other contracting frictions. First, side letters create a prisoner’s dilemma for fund investors. Investors collectively would be best served by not negotiating them at all. Yet, each individual investor has an incentive to defect from this arrangement: as soon as one investor obtains a side letter from the sponsor, others should seek to obtain one as well. Second, on the sponsor side, there is a widespread belief that limited partnership agreement terms are “sticky” over time. Whether accurate or not, this belief drives sponsors to include the most sponsor-favorable terms possible in the limited partnership agreement, while relegating investor-favorable terms to side letters. Third, lawyers have played a major role in the burgeoning of side letters. The small set of elite law firms that represent large sponsors view their respective limited partnership agreement templates as proprietary: they maintain their “brand” by not permitting any investor-friendly modifications to the limited partnership agreement and by insisting that all documentation in the industry remain confidential. On the investor side, counsel has failed to settle on standardized language for common side letter provisions because they have little economic incentive to coordinate and to reduce their billings.

Our findings also have important theoretical implications for the emerging academic discourse on contract modularity.  While recent scholarship has justly highlighted the benefits of modularity in the contractual design of complex deals, little has been written on the potential downside of contract modularity.  Our findings shed light on one cost of modular design—the potential for over-modularity. In the multiparty, opaque structure of private equity fund formation, modular design may lead to excessive negotiation and costs and inefficiently push contractual provisions from the limited partnership agreement (the main agreement) to side letters.

Given these findings, we offer several prescriptions for reforming side letter practice, with the aims of reducing complexity and returning more of investors’ desired terms from side letters to the limited partnership agreement.

To reduce the complexity of side letters, we recommend: (1) standardizing the provisions designed to address investors’ regulatory and tax concerns, because these risks are functionally identical for all investors of a given type; (2) encouraging, rather than discouraging, sponsors to make any price discrimination among investors explicit in the limited partnership agreement itself, as this would lessen the incentives to discriminate among investors indirectly (and inefficiently) in side letters or through unwritten “gentlemen’s agreements” regarding co-investment; and (3) making sponsors bear their share of the legal cost of side letter negotiations.

To ease the side letter arms race among investors, we recommend: (1) requiring side letters to be disclosed to all investors in the fund; (2) moving to the limited partnership agreement (a) all side letter provisions that could negatively affect other investors in the fund and (b) all side letter provisions promising additional reporting or other disclosures by the fund or the sponsor. Indeed, our empirical review of side letter provisions across a large sample of funds reveals no compelling justification for keeping such provisions confidential among investors, whereas disclosing them could dampen investors’ enthusiasm for individualized side letters and facilitate greater coordination among investors in negotiating against sponsors.

Finally, we discuss how investors, sponsors, and regulators might best implement these recommendations and whether regulation or private ordering is better suited to the task. We also highlight how the private equity industry’s deference to path-dependent outcomes, its insistence on secrecy for all documentation, and its failure to simplify and standardize documentation have thrown open the door to the type of regulation that it has always claimed neither to need nor to want.  At the same time, the SEC’s recent proposed regulations fail to address some of the real concerns that side letters present.

The complete article is available for download here.

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