Side letters have long been a standard piece of the relationship between funds and their investors, especially when emerging managers, defined as those running Funds I, II or III, need to negotiate specific terms with anchor investors to get their funds up and running. They are often used to grant additional rights to an investor beyond the limited partnership or equivalent document signed by all investors. Common side letter rights are rights to a limited partner advisory committee seat, the right to request financial information, reduced management fees or carried interest, and a most favored nation clause requiring that the fund grant the recipient of the side letter any preferential treatment granted to other investors of like size.
Partially for fund administrative reasons, it has been the market standard for a side letter’s contents (and even existence) to stay private—that is, until recently.
In 2023, the Securities and Exchange Commission adopted what became known as the “Private Funds Rule.” Officially, the SEC adopted the Private Funds Rule to increase private funds’ transparency regarding fee structures, expenses, and relationships with their investors. To achieve this increased transparency, the SEC enacted several rules, including the near-mandatory disclosure of one investor’s side letter terms to any subsequent investors, which ultimately meant that all other investors would request the same rights received by the side letter holder, making it even more difficult for an emerging manager to raise funds and create a sustainable fund management business model.
The Fifth Circuit Court of Appeals struck down the Private Funds Rule in June. While the ruling’s impacts are wide-reaching enough to warrant the publishing of several articles, its impact on emerging fund managers and small funds is unique in the private fund community.
Emerging funds are often in a unique position in that they lack the negotiating power that an established manager has with potential investors. Established fund managers may negotiate under a model of “I have an established track record, so I am selecting my investors.” First-time or emerging fund managers, however, often operate under a model of “I must have the capital to establish a track record, so I very much need investors.” Prospective investors know that an emerging fund manager is in this position and will heavily negotiate the terms of their investments. A side letter codifies this agreement between the fund and the investor and allows the emerging manager to start building that investment track record with the investor’s capital.
The most common scenario that demonstrates the above is when an institutional investor, like a pension fund or large investment arm of a company, wants to invest. Having one of these investors on its schedule of partners would be a major boon to the emerging fund and likely attract more high-caliber investors. The significant investor knows this and will ask for items like a board seat, reduced management fee payments, or a change in its capital contribution timeline. Realizing the impact that the large investor money may have, the fund is more than happy to grant these rights in a side letter.
After receiving the side letter, the large investor invests, and other established investors see this investor on the cap table and invest. Then, the emerging fund manager’s need for capital becomes much less of a problem.
However, if the law required the fund to disclose the terms of that side letter to all subsequent investors, this becomes highly problematic. While the SEC like wrote the rule to prevent large funds from harming smaller, everyday investors, the rule would have an outsized impact on smaller, emerging funds.
With egos brimming in private fund investment, mandatory disclosure presents an obvious problem: Most subsequent investors would want the same or similar terms as the much larger investor. Not only would having to deal with this slow the pace of closing investment, it is likely a mission an emerging fund manager is unprepared to undertake. Because of this, such managers may fly by the seats of their pants while negotiating side letter terms, or hire experienced advisors. Choosing either of these options costs emerging funds two things that they are all in short supply of: time and money.
Another problem manifested by mandatory disclosure is one that established funds know much about and that emerging funds will painfully become aware of: compliance costs. One of the most significant costs in launching a fund is compliance with all federal and state securities laws. These costs already make survival difficult for emerging funds. Tracking side letters and ensuring the proper investors receive notice of their key terms would have likely made the weight of compliance even heavier upon funds.
As one can see, overturning the Private Funds Rule eased some enormous potential burdens on emerging funds and their managers. The SEC’s attempted implementation of the rule continues a recurring pattern of the Commission failing to consider the impact of its policies on smaller, emerging funds. While the Commission rightfully aims to protect investors, its recent rulings and attempted implementations may have the opposite effect by chilling the number of emerging managers and the funds available for investment to seed much needed businesses across the country.
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