Date01 April 2023
AuthorDe Fontenay, Elisabeth


A standard feature of the private equity industry, "side letters" are confidential agreements between the sponsor and individual investors that give the latter special rights, beyond those that apply to other investors in the private equity fund. Yet side letters have become a flashpoint for prominent critics of the industry, who argue that they allow private equity sponsors to benefit their favored investors at the expense of smaller, less sophisticated ones. Others have argued that, to the contrary, side letters are merely an efficient means of price discrimination--charging different prices to different investors, according to their willingness to pay--a practice that is common and well accepted in other industries.

We find fault with both views. We provide a novel empirical analysis of side letters, which disproves some of the most common claims about their content. Specifically, we code the terms of each side letter in a handcollected sample from thirty years of buyout funds. Contrary to the conventional wisdom, we find that side letters very rarely grant fee discounts to investors or otherwise reallocate the fund economics among investors. Instead, side letters are mostly designed to accommodate a fund investor's regulatory and tax concerns. The view shared by both critics and proponents--that side letters are primarily used to treat investors differentially--is largely mistaken.

Side letters remain problematic, but for very different reasons than those raised by critics. We show that side letters have grown substantially in both length and complexity over time. They impose significant costs and delay on private equity capital-raising, and they potentially impinge on funds ' operations and investments in unexpected ways. Over time, they have prompted an inefficient arms race among investors, leading to ever longer negotiations and more complex contractual networks for private equity funds, with little benefit for investors or sponsors. Using qualitative interviews with key participants in the industry, we explore the causes, including lawyer agency costs and other contracting frictions.

This Article makes three key contributions to the literature. First, using a novel, hand-collected and hand-coded dataset of side letters, it provides much-needed insight into one of the most guarded industries in the U.S. economy. Second, in contrast to the prevailing view in the contract modularity literature, this Article provides a cautionary tale regarding "over-modularity " and its costs. Finally, this Article offers several timely policy recommendations, arguing that, paradoxically, the current inefficient bargaining equilibrium is likely due to the relative lack of regulation of private equity funds. The industry would be better served with either regulation or coordinated industry action focused not on imposing uniform fund economics, but on ensuring more standardized documentation across investors and funds.

TABLE OF CONTENTS INTRODUCTION I. PRIVATE EQUITY AND THE RISE OF SIDE LETTERS A Brief Primer on Private Equity Funds and Leveraged Buyouts. B. What We Know (and Don't Know) A bout Private Equity C. The Side Letter Phenomenon II. DEMYSTIFYING SIDE LETTERS: EMPIRICAL ANALYSIS A. Methodology B. Sample Description C. The Evolution of Side Letters III. HOW DID WE GET HERE? THE SIDE LETTER DILEMMA A. The Cost of Side Letters B. The Sponsor's Incentives C. The Investors' Incentives D. The Lawyers' Incentives E. Contractual Over-Modularity F. Interview Methodology IV. RECONCEPTUALIZING SIDE LETTERS A. Reducing Side Letter Complexity B. Back to the Limited Partnership Agreement C. Implementation D. A "Sea Change A Critique of the SEC's Suggested Reform CONCLUSION APPENDIX "Private fund advisers, through the funds they manage, touch so much of our economy. Thus, it's worth asking whether we can promote more efficiency, competition, and transparency in this field. "

--SEC Chair Gary Gensler (Feb. 9, 2022)

"It's the territory where everyone hates each other, but at least you've spent a shitload of money on legal fees so all the lawyers involved can go buy a new boat. "

--Anonymous quote on the proliferation of side letters (1)


On a chilly November evening in 1988, the "barbarians" finally breached the gates of RJR Nabisco, the American manufacturing conglomerate. After a bitter struggle, the private equity investment group Kohlberg, Kravis, Roberts & Company (KKR) won a bidding war to complete a leveraged buyout of RJR Nabisco. (2) On November 30, 1988, after more than a month of heated bidding and multiple rounds of negotiations, KKR succeeded in buying out RJR Nabisco for a record price of $25 billion--the largest leveraged buyout ever at the time. (3) KKR completed this deal despite only investing $15 million of its own money, (4) using other investors' equity and significant debt as the key to finance the deal. (5)

Dubbed the Barbarians at the Gate by the iconic and best-selling book (and subsequent Hollywood movie), KKR's acquisition of RJR Nabisco marked the emergence of private equity funds as major players in the U.S. capital markets and in the governance of corporations. (6) While news outlets focused on RJR Nabisco CEO F. Ross Johnson trying to fend off the "barbarians" who wanted to take away his private planes and lavish lifestyle, little attention was paid to the underlying investors in the KKR fund who funded the $1.5 billion in equity (7) for the transaction, or to the relationship between these investors (8) and KKR itself. "[T]he retirement funds of companies such as Coca-Cola, Georgia-Pacific, and United Technologies; the endowment funds of [MIT] and Harvard, and the pension funds for state employees of New York, Iowa, and Michigan," all were key investors in the KKR fund that acquired RJR Nabisco, (9) but their investment and how it was managed remained in the shadows.

Private equity has since grown to represent a mammoth industry. Among the different private equity investment strategies, buyout funds alone hold over $2 trillion in assets under management worldwide. (10) Over time, buyout funds have become a key financial player in the American economy, having acquired some of the most prominent U.S. corporations and prompted a revolution in the corporate debt markets. Yet, despite its large impact on Americans--its investors represent a large swath of the retirement savings of U.S. households--the private equity industry has been operating under a veil of secrecy, with the key agreements between the investors and the sponsors hidden from the public eye. (11)

In a leveraged buyout, a private equity fund acquires a company using a high proportion of debt ("leverage"), then seeks to optimize the company's operations, governance and strategy before eventually exiting the investment through a sale or public offering ("buyout"). (12) Yet private equity buyout funds are distinct not only in their investment strategy--buying and selling whole companies--but also in the formation of the funds themselves. The sponsor (13) that sets up and manages the buyout fund enters into a long term agreement with investors that governs the relationship among them. (14) This agreement, formally a limited partnership agreement (or LPA), typically bestows on all investors in the fund the same rights and obligations. Over time, however, this simple and uniform structure has become far more complex: sponsors routinely enter into separate agreements (or "side letters") with some or all of their investors, under which each investor in question is granted a tailored set of additional rights. Depending on the fund, the terms of any given side letter need not be disclosed to the other fund investors.

This feature of the private equity industry has finally come under the spotlight and provoked greater regulatory interest, (15) public attention, (16) and investor concern, (17) culminating in a new and sweeping regulatory intervention. On February 9, 2022, the Securities and Exchange Commission (SEC) voted to propose new rules that, among other changes, specifically address side letters for private investment funds such as buyout funds. (18) The SEC's proposed rules have already triggered what is likely to be a very long battle with fund sponsors and their counsel. (19) Thus far, however, neither side has mustered data to support its preferred policy approach.

Broadly speaking, side letters have elicited two opposing views among policy-makers and academics. The first views them as nakedly exploitative: by enabling sponsors to grant special (and secret) rights to favored investors, side letters put smaller, less sophisticated investors at an economic and informational disadvantage. (20) In this view, the fact that investors in the same fund may be treated very differently is inherently unjust. (21) Senator Elizabeth Warren (D-Mass.) and others have at times called for a flat prohibition on side letters for this very reason. (22) The most recent SEC rule proposal explicitly reflects this view, arguing that side letter terms "can have a material, negative effect on other investors." (23)

The second view argues that side letters--together with other tailored arrangements between private equity sponsors and specific investors, such as co-investments--are simply a form of price discrimination. (24) According to standard economic analysis, under some conditions a sponsor will raise the most capital and achieve the most efficient collective outcome by classifying investors according to their willingness to invest in the sponsor's fund and charging each group a different "price" (in this case, the compensation or "fees" payable to the sponsor for managing the fund). (25) Rather than nefarious collusion between sponsors and the most sophisticated investors, side letters are, according to proponents, simply a rational and efficient response to the fact that private equity investors differ in their...

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