A private equity firm with 10 different funds could have hundreds of side letters attached to each fund. Many firms will rely on expensive outside counsel to manually track these obligations.
While the SEC backed away from banning preferential treatment all together, the final rules do prohibit preferential treatment that would have "a material, negative effect on other investors".
Otherwise, the new rules allow preferential treatment as long as the various different economic terms offered in side agreements are disclosed to all investors.
Counting the cost of the new rules
The new rules are likely to significantly increase compliance and reporting costs for private equity funds and it is hard to see smaller funds taking on these additional requirements without increasing fees for investors.
The requirements on disclosing preferential treatment will significantly increase the administrative time and resources needed to maintain, update and manage obligations.
They will also increase the complexity of fundraising as every new side agreement will need to be disclosed to every investor, which may in turn require new individual obligations.
There will be a real challenge in the tracking and flow of information during the closing process.
What’s more, the SEC did not define ‘material or negative effect’, so fund managers and their legal teams must make individual judgement calls on whether certain preferential treatment is allowed or not.
All in all, as a result of these new rules, the side letter, which has become a staple of the private equity industry, becomes a very complicated and legally challenged document. Perhaps one saving grace is that the new rules do not apply to existing contracts and agreements.
Mitigating the impact
Some of the impact of these new rules could be mitigated if the industry took a less manual and more technology-first approach to compliance.
To date, many fund managers rely on expensive outside counsel to essentially maintain excel spreadsheets to track side letter obligations as well as other reporting obligations.
The latest technologies can significantly improve this process, saving fund managers time and money as well as ensuring they do not fall foul of missed obligations or compliance requirements.
Generative artificial intelligence systems for instance, which are based on large language models that have been trained to understand contracts and side letters, would give private fund managers the ability to search and find information they need across all their agreements in seconds or to compare clauses contained across hundreds of different side letters.
What’s next?
The new rules take effect 18 months after they appear in the Federal Register – that is unless the industry’s legal challenges are successful, and the SEC is forced to look again at its proposals.
