LPs to SEC: Save our side letters

Managers at some of the world’s largest pension funds and endowments are urging the US Securities and Exhange Commission to scrap proposed rules that would require private funds to share side letters with their investors.

For more than a year, the Commission has been weighing sweeping new reforms that would, among other things, require funds who give “preferential terms” to favoured investors to share the details of the side letters with other investors. The rules would also ban a host of fees and expenses and require all funds – registered or not – to audit their books yearly and share the results with regulators and investors.

The proposals have sat at the Commission for so long in part because many institutional investors – the core constituency for the changes – are not happy with the side letter provisions, affiliate title Regulatory Compliance Watch has learned.

Advocates for such limited partners say side letters give them flexibility to negotiate the best deals for the pensioners, universities and sovereign wealth funds they represent. The disclosure requirements, they said, would kill side letters. Any reforms, they said, should “raise the floor” – create minimum standards of disclosures – not lower the ceiling, said Neal Prunier, senior director of industry affairs at the Institutional Limited Partners Association, one of the largest trade associations for pension funds and other limited partners.

“Directionally, we’re thrilled with the governance, transparency and alignment of interests in the rules package,” Prunier told RCW. “Banning important side letter terms that cover required governance, statutory or regulatory protections LPs have been accustomed to negotiating is a bit more problematic.”

Caught off guard

Other limited partners have also joined the cause. In November and then again in January, officials from Duke, Stanford, Notre Dame, Yale, the University of Michigan and the University of Virginia joined executives of the Regulatory Fundamentals Group to lobby the SEC away from the proposed side letter ban.

If adopted as written, the new rules “would harm investors by reducing overall transparency and liquidity options without an overriding benefit”, Regulatory Fundamentals CEO Deborah Prutzman said in a 3 December letter to the Commission. “We are concerned about the ability to access diversified investments in a manner that is consistent with the goals, fiduciary obligations and mandates of our non-profit missions. Put differently, the potential purported benefits from Proposed Rule 3(a) do not come close to outweighing the potential widespread harm we, as investors, will experience.”

Private fund advisers and their advocates are not fans of the rule proposals. They have been urging the Commission to toss them out altogether. They have promised to sue to block them. Sources close to SEC chairman Gary Gensler tell RCW he expected that. However, he did not expect blow-back from institutional investors – especially ILPA, the sources say. One of Gensler’s first speeches as chairman was at the ILPA. He condemned private fund fees and promised to shore up industry fiduciary standards.

Two months later, the Commission proposed the new private fund rules. Barely a month after that, the ILPA began lobbying against the side letter provisions, and against proposed rules that would prevent private funds from indemnifying themselves against negligence. Gensler was caught off guard, the sources said. They spoke to RCW on condition of anonymity because Commission deliberations are supposed to be secret.

More friends

On 6 March, the ILPA released a new white paper underlining its points. “Side letters”, it states, “are critical for investors and the private equity industry. Many institutional investors are required to receive governance, statutory or regulatory protections that are specific to their institution to invest in an asset class as sophisticated as private equity. LPs rely on side letters to secure these provisions. In fact, 76 percent of LP respondents in both 2020 and 2022 identified their organisation would not be able to invest in private equity without side letters.”

Not every pension manager feels as strongly as the ILPA does. On 24 February, Gensler and his staff met with a delegation that included leaders from the AFL-CIO, which is the largest US federation of unions, and the Communications Workers of America, Commission records show. Those two unions are in favour of Gensler’s reform proposals.

But given the pressures from his own party on the scale and speed of his reforms, the division among institutional investors, new Republican leadership in the House, near-universal hostility from the financial services industry and given his own preferences to focus on market structure reforms, Gensler feels he needs more friends to get private fund reforms done, sources say.

‘So much of our economy’

Officially, Gensler has not given up the cause. For months after the new rule proposals came out, he was mum. In February, he made a fresh pitch for reform to the Commission’s Investor Advisory Committee. His core argument had not changed in the year since he and his colleagues put the rule proposals out for comment: private funds, he says, have gotten too big to fail.

“Given that these funds touch so much of our economy,” he told the advisory committee, “efficiency and competition among these intermediaries is important. That’s why I supported our proposal to require registered private fund advisers to provide detailed reporting to investors of fees, expenses, performance and preferential treatment, such as side letters”.

Gensler’s Democratic colleague, Caroline Crenshaw, has not wavered in her support for new private fund rules. That leaves the newest Commissioner, Jaime Lizárraga, as the swing vote. Lizzaraga was a longtime aide to former House speaker Nancy Pelosi. He helped shepherd the JOBS Act through Congress, which supercharged the private fund industry after the Great Recession.

Lizárraga has spoken little about private fund reforms since he joined the Commission in July. Earlier this month, he urged the advisory committee to ask themselves whether retail investors, or even accredited investors, were being locked out of the private fund market by institutional investors. Commission records show that only two groups have talked to Lizárraga about the pending private fund reforms. The Managed Funds Association met with him and his staff on 8 November, records show. The American Investment Council came in to see him 18 January. Both groups oppose the proposals.

This article first appeared on affiliate title Regulatory Compliance Watch