A while back, I posted about the SEC’s proposal to adopt new rules on private investment funds.  Among other things, the SEC expressed concern about “side letters,” namely, tailored agreements with specific investors in particular funds, giving those investors preferential terms regarding information, redemption rights, and similar matters, as compared to other investors in the same fund.

Which is why it’s very timely that two new papers have been posted to SSRN conducting empirical analyses of what these side letters contain.

The first, Side Letter Governance, by Elisabeth de Fontenay and Yaron Nili and forthcoming in the Washington University Law Review, finds that side letters rarely offer financial preferences; instead, fund sponsors favor particular investors by other means, such as separate accounts and co-investment opportunities.  They do, however, find that side letters have become overly complex and difficult to negotiate, in part because each investor wants to make sure that it is not placed at a disadvantage relative to other investors in the fund.  They recommend, among other things, that all side letters be disclosed to other fund investors, and that certain provisions – concerning investors’ tax and regulatory concerns – be standardized across different investor types.

The second, Shadow Contracts, by Jessica S. Jeffers & Anne M. Tucker and forthcoming in the University of Chicago Business Law Review, focuses specifically on side letters in impact investing.  They also conclude that side letters have become overly complex due to a lack of standardization and transparency, but point out that side letters associated with impact investing impose additional costs because investors have different idiosyncratic goals.  They argue that the norms developed for private equity around confidentiality are a poor fit for the impact space, and, unlike de Fontenay and Nili, find that a significant percentage of side letters do confer financial benefits on favored investors, such as fee reductions and guaranteed co-investment opportunities.

With so much investment moving into the private space, it is critical that we have more visibility into how these markets operate; these papers provide valuable insight.