Since their introduction in the late 1980’s, side letters have been a staple of the private equity industry, granting limited partners (LPs) special rights beyond those outlined in limited partnership agreements. Over time, these agreements have evolved, reflecting the shifting dynamics between LPs and general partners (GPs). In today’s private investment landscape, side letters are widely used, presenting challenges for chief financial officers (CFOs).
Understanding Side Letters
Side letters are typically requested by LPs to reduce their risk. Common provisions include the most favored nation clause (which protects an investor by giving them the same rights and benefits received by later investors if those rights are more favorable than those originally agreed upon), fee structures, redemption rights, notice of significant redemptions, the use of placement agents, confidentiality, and ESG commitments, among others.
Despite their utility, side letters have earned a negative reputation over the years for favoring larger investors at the expense of smaller ones. Their confidential nature has also drawn scrutiny from LPs and regulators alike.
Regulatory Spotlight
Side letters have caught the attention of global regulators. Although there is no restriction on the use of side letters, transparency is becoming a core expectation. For instance, the U.S. Securities and Exchange Commission’s (the “SEC”) Private Funds Rule (which was ultimately not adopted) aimed to increase private funds’ transparency regarding fee structures, expenses, and relationships with investors. If it had been adopted, private fund advisers would be required to disclose investor side letter terms to all investors. Since the rule was struck down by the Fifth Circuit Court of Appeals in 2024, there has been a notable increase in side letter usage.
The Increasing Burden on CFOs
As the use of side letters has expanded, so has the administrative burden on CFOs. These agreements demand meticulous tracking, compliance monitoring and coordination across teams, taking CFOs’ attention off of core business activities.
A Framework for Managing Side Letters
To navigate the challenges of side letters, CFOs must adopt proactive strategies.
- Develop a Strategy: Begin with a roadmap. Identify which LPs are likely to request side letters and terms the GP will be comfortable agreeing to, and assign a person at the GP to be responsible for monitoring compliance. Align early with partners and legal and compliance teams to ensure side letters reflect broader business goals and governance standards.
- Draft Side Letters Carefully: Collaborate with legal, compliance, and accounting teams before finalizing side letter terms. Ensure consistency with other fund documents and record all approvals in writing to avoid misunderstandings down the line.
- Manage Onboarding and Costs: Negotiating side letters can delay LP onboarding and increase legal costs. By establishing standardized approaches to common requests, GPs can expedite the process while maintaining flexibility.
- Invest in Systems and Processes: Side letters demand ongoing monitoring and reporting which can be cumbersome to track in spreadsheets. Implementing systems and processes can help CFOs monitor compliance and manage the complexity of overlapping obligations. These tools can also centralize the documentation and assign tasks, creating operational efficiencies.
The Value of Side Letters
While side letters add complexity, they also offer significant value. These agreements enable funds to attract LPs by tailoring terms to meet their individual needs. With planning and the right resources, CFOs can mitigate the administrative burden of monitoring side letter terms by establishing a plan from the start and adding systems and tools to help them ensure compliance.