Client Alerts  - Private Equity and Venture Capital Aug 18, 2023

The Future of Side Letters Under the SEC’s Proposed Rules for Private Fund Advisers

SEC Proposes Rule Changes on Private Fund Side Letters

In February 2022, the Securities and Exchange Commission (SEC) issued proposed new rules (“Proposed Rules”) that, if adopted, would impact the SEC’s current practice and approach towards the regulation of private investment funds pursuant to the Investment Advisers Act of 1940, as amended. The Proposed Rules were intended to offer greater transparency and address investor protection concerns by establishing additional regulatory compliance obligations on all private fund advisers, regardless of registration status with the SEC.

Among the series of additional regulatory obligations, the Proposed Rules contemplate an outright restriction on all private fund advisers from entering into certain types of side letters or similar arrangements (“Side Letters”) and require private fund advisers to provide written disclosures of preferential terms provided to select prospective and current investors in a private investment fund. While these rule changes would address the information asymmetry that exists between private fund advisers and investors brought about by opaque preferential arrangements inherent in Side Letters, industry participants and commentators fear that it will increase costs, create new barriers to entry and, overall, add yet another layer of complexity to what is typically an already elaborate negotiation of terms in the capital-raising process. A more detailed discussion of Side Letters and the envisioned treatment of these arrangements under the Proposed Rules is provided below.

Side Letters

Side Letters are strategic agreements entered between private investment funds and select investors to provide those investors with different or more favorable terms than the standard terms set forth in the fund’s standard offering documents. These letter agreements generally grant certain additional rights to significant investors (or investors with certain limitations, restrictions or other special considerations), such as “most favored nation” rights, co-investment, information, advisory board rights, and other investor-specific arrangements.

Prohibited Preferential Treatment Under the Proposed Rules

The Proposed Rules strictly prohibit Side Letter arrangements allowing select investors to enjoy the following types of preferential treatment:

  • Prohibited Preferential Redemptions: Granting preferential liquidity terms (e.g., redemption rights) that the private fund adviser reasonably expects to have a material, negative effect on other investors in that private fund or in a substantially similar pool of assets (e.g., another feeder fund investing in the same master fund).
  • Prohibited Preferential Transparency/Selective Disclosures of Portfolio Information: Providing selective information about the portfolio holdings or exposures to certain investors if the private fund adviser reasonably expects such information to have a material, negative effect to other private fund investors.

With respect to other kinds of preferential treatment, the Proposed Rules contemplate that a private fund adviser must furnish investors with written disclosures that certain rights have been provided to other investors in the same private fund (e.g., excuse rights to accommodate unique investment restrictions, fee discounts, or the right to increase an investment in a private fund). The Proposed Rules require these disclosures to include specific information regarding any preferential treatment afforded to select investors. For instance, mere notice of lower fee terms for other investors would be insufficient disclosure. Instead, an adviser would be required to specifically furnish specific details regarding such lower fee terms, including the applicable rate. Alternatively, a private fund adviser could comply with the proposed disclosure requirement by providing copies of Side Letters (with redacted identifying investor information) or a written summary of the preferential terms provided to investors, so long as the summary particularly describes the preferential treatment. The notices required under the Proposed Rules must be given to a prospective investor prior to an investor’s investment and to existing investors via an annual notice. These written notices must also be maintained by private fund advisers to demonstrate compliance with the Proposed Rules.

Practical Considerations and Proposed Next Steps

The Proposed Rules do not clearly define “preferential treatment” or otherwise provide extensive guidance on the benefits that would meet this standard. If the Proposed Rules relating to Side Letters are adopted in their current form, private fund advisers will need to catalog internally what constitutes preferential treatment and the scope of information to be included in notices to prospective and current investors.

While the final rules may differ substantially from the current version set forth in the Proposed Rules, they nonetheless have the potential to significantly change the regulation and operations of private funds and their advisers. Private fund advisers and investors, must consider how the Proposed Rules would impact their cost of compliance, capital raising process, investor relationships, the terms pursuant to which investors invest as well as the ability of private fund advisers to market private investment funds to certain investors.

In the meantime, private fund advisers should consider the implications of the Proposed Rules, which could include the following:

  • Fund Documents: The Proposed Rules do not contain a grandfathering provision and, thus, the associated obligations would apply to existing contractual arrangements. Given this, private fund advisers should review existing fund documents to consider steps required to bring them into compliance with the Proposed Rules.
  • Existing Side Letters: Private fund advisers should revisit the terms of Side Letters previously issued which may be implicated by the Proposed Rules’ prohibitions.
  • Investment Process: Private fund advisers should assess and evaluate what terms may effectively be offered to investors if the Proposed Rules are approved in their current form.
  • Disclosures and Notice: Private fund advisers should consider the steps involved in implementing disclosure and notice procedures that comply with the requirements of the Proposed Rules.

Additional Assistance

Attorneys in the Private Equity and Venture Capital Practice Team at Phillips Lytle LLP are available to provide further guidance regarding the Proposed Rules. For further assistance, please contact Patrick T. Fitzgerald, Benjamin M. Farber or the Phillips Lytle attorney with whom you have a relationship.

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