SEC cracks down on private fund side letters

The U.S. Securities and Exchange Commission (SEC) headquarters in Washington, DC, at dusk.

The side letter has been a particularly effective tool in the private fund industry, with funds and investors entering into strategic arrangements to provide more favorable terms than those given to other investors in standard offering documents.

Significant investors often request additional rights as a condition to invest, including board advisor positions, enhanced information rights, and “most favored nations” protections. Historically, funds could freely enter into side letters with investors, but the Securities and Exchange Commission adopted new rules on Aug. 23 (the “New Rules”), placing limitations on this practice. The SEC believes the New Rules enhance transparency and expand investor protections, but as one commenter noted, “fair treatment of all investors does not necessarily mean identical treatment of all investors.”

The New Rules restrict preferential terms in side letters through extensive disclosure requirements, consent requirements, and even the outright prohibition of certain terms when there would be a material negative effect on the other investors.

Unfortunately, the New Rules do not define “preferential terms,” but rather place the burden on the fund and its adviser to determine which practices are subject to the New Rules. When applicable, advisers may satisfy the disclosure requirements by providing a detailed summary of the preferential terms or the actual language of the side letter. Although objected to by multiple commenters due to the potential compliance burden, advisers must disclose all preferential terms contained in side letters entered into prior to the New Rules. There is an exception for preferential terms in pre-existing side letters which would otherwise be prohibited under the New Rules, so such terms are permitted to continue if funds meet certain criteria (including disclosure).

The side letter is not dead. Moving forward, a fund’s adviser must provide advanced disclosure of material economic preferential terms given to an investor before such investor is admitted to the fund, and then on an annual basis thereafter. Further, any new or amended preferential terms must be disclosed to all other investors “as soon as reasonably practicable” (with the expectation being within four weeks).

Compliance is required within 12 or 18 months of the adoption of the New Rules depending on the amount of an adviser’s private funds assets under management. Funds should consult with counsel for a comprehensive review of the New Rules and to create procedures to comply thereunder.

This article appeared in the December 14, 2023, issue of The Journal Record. It is reproduced with permission from the publisher. © The Journal Record Publishing Co.