A bit of opacity on the side

It’s almost trite to talk about transparency; there’s not much left to do,” Stewart Kohl, co-CEO of Riverside told pfm recently.

Whether or not you agree with him, there is no doubt that limited partners are demanding and receiving more data than ever on portfolio companies, and the industry as a whole is opening channels of communication with the wider community.

Influential LPs are doing more to understand their fees and expenses. In November, for example, the California Public Employees’ Retirement System presented the total costs and fees paid to manage its private equity portfolio; to do so it collected data related to all 600-plus investments through direct engagement.

“On the issue of transparency and disclosure, you have to be seen as the new leader,” then-consultant Pension Consulting Alliance said at the time.

But while certain forces push transparency to new levels, others are pulling in the opposite direction. The growing importance of side letters to limited partnership agreements fits in the latter category.

One London-based fund lawyer said sponsors should anticipate that every investor in their fund will request and expect to receive a side letter.

“The increasing importance of side letters is moving the industry away from transparency; it doesn’t help transparency as everyone is seeing different documents,” said Eamon Devlin, who leads the legal practice at MJ Hudson.

This was echoed by an IR professional who recently led a successful fundraise. His team had to accommodate more, and longer, side letters than ever before, he told pfm. The biggest driver in this case was individual reporting requirements. “Fund reporting and information flows need to be individualized for each investor and that takes a lot of work,” the source said.

Side letters vary in length and complexity, but it’s not unusual for them to exceed 25 pages. Devlin said a fund his firm recently worked on compiled a 500-page side letter.
Among the issues prompting the proliferation is the growing vogue for co-investment. Terms for co-investment are rarely included in the LPA, say sources, and investors are negotiating their own.

In a survey of all co-investments it advised on in 2016, MJ Hudson found that some LPs – particularly those who GPs feel are crucial to raising future funds – are using side letters to negotiate preferential co-investment deal rights and fee levels.