A lack of transparency has been a long-standing criticism aimed at the private equity industry – and private markets in general. So, on the face of it, the Securities and Exchange Commission’s proposal earlier this year to restrict the use of side letters offering “preferential treatment” to some institutional investors and not others would seem like a positive development.
Through that lens, pushback from an LP such as the Los Angeles County Employees Retirement Association, which last week included a letter it had written to the SEC in its board meeting materials supporting these bespoke agreements, might seem surprising.
While the $73 billion US pension fund supports the disclosure of fees managers charge LPs, it is opposed to “the proposed rule’s provisions that may limit investors’ ability to negotiate side letters”. That’s because LACERA uses these side agreements to secure the ESG-related reporting it requires from the fund managers it invests with. From our canvassing of the market, they are not alone in doing so, and this is particularly true for managers – including infrastructure ones – outside of the European Union.
Of course, side letters are not about ESG – or at least, they weren’t initially.
“This tiering of terms is quite common and it is to incentivise LPs to either make a larger commitment, invest at an earlier stage of the fundraising cycle or create co-investment clubs,” one source tells us, referring to the “more classic commercial terms” of management fees and expenses, which created the need for side letters in the first place.
But as ESG has become an increasingly important component of private fund investing, side letters have evolved to include related reporting requirements specific to any given LP.
As Jan Straatman, a partner and head of ESG at London-based Astarte Capital Partners, explains: “It is not always possible to capture everything in the official original fund documents. We recognise the need of some LPs to receive additional details [in an ESG] context, which they sometimes like to reflect in a side letter, rather than having to change all fund documentation.”
Our source goes further, pointing out that LPs differ not only in terms of their ESG criteria and reporting requirements but also in terms of their size, sophistication, investment needs and strategy. “I think LACERA has a point when they say ‘side letters are a crucial means for market innovation’. If you try to level the playing field, you’ll end up with the lowest common denominator, and that’s very low.”
Ending up with the lowest common denominator – particularly when it comes to enforcing ESG standards – is not a prospect we relish for an asset class in the business of running essential assets. In that sense, we are not keen on the potential removal of a tool that allows investors to obtain the ESG information they need from their GPs.
That isn’t to say side letters are the best tool for this. As our source points out: “The EU’s SFDR [taxonomy] more directly addresses the issue of ESG reporting, benchmarking and creating clear standards. That’s a much more efficient way of dealing with this than using side letters.”
Until we have much more broadly applied standards, though, keeping all the tools at our disposal – even the more imperfect ones – seems like a better way to go.