How SEC’s Private Fund Rules Will Affect Use of Side Letters

Recent client alerts have provided an overview of the new “private fund rules” adopted in late August by the U.S. Securities and Exchange Commission (SEC). These rules apply, subject to limited exceptions and carveouts, to all private funds and their advisers, regardless of whether they’re subject to federal or state regulators. These recent alerts discuss the most pertinent aspects of SEC Release No. IA-6383 and summarize the new private fund rules adopted by the SEC pursuant to said Release (the “New Rules”).  In this article, we will consider some of the potential impacts that the so-called Preferential Treatment Rule (Rule 211(h)(2)-3) (“Preference Rule”) and Restricted Activities Rule (Rule 211(h)(2)-1) (“Activities Rule”) may have on a common tool used by real estate private equity fund advisers: side letters. Before discussing the impact on private fund managers’ use of side letters, a quick discussion of side letters and brief summary of the rules would be helpful.

What is a Side Letter in the Private Fund Context?

Side letters are private agreements entered into between private funds (via their advisers) and certain investors that provide those investors with different — often more favorable — terms and rights than are afforded to the other investors in the private fund pursuant to the offering documents. Side letters may serve different purposes in the private fund context, but they generally confer upon the investor so-called “most favored nation” rights, including but not limited to investor-specific redemption, co-investment, alternative fee arrangement, and informational and advisory board rights. While side letters are typically used to negotiate preferred terms to attract and retain large investors, they are often used to allow a private fund and its advisors to meet institutional investors’ own internal policies, which policies generally exist to enable the investor (or its advisers, family office, etc.) to remain in compliance to any relevant laws, rules and regulations to which such investors are subject.

Preferential Treatment Rule (Rule 211(h)(2)-3)

The Preference Rule prohibits fund advisers from either directly or indirectly (i) providing preferential redemption terms to an investor in a private fund or “similar pool of assets” that the adviser reasonably expects to have a material, negative impact on the co-investors of the fund or pool, or (ii) providing certain information about specific fund portfolio assets or exposures to any investor if the adviser reasonably believes that providing such information would have a material, negative impact on co-investors in the fund or pool, subject to certain exceptions not discussed at length here. Aside from seeking to further restrain certain unsavory practices, the Preference Rule seems specifically aimed at eroding the “most favored nation” status that certain investors enjoy.

Restricted Activities Rule (Rule 211(h)(2)-1)

The Activities Rule places restrictions upon certain practices of private fund advisers, even where the fund’s offering documents expressly permit such practices, unless the advisers comply with newly adopted disclosure and, in certain instances, consent requirements laid out in the rule (including exceptions thereto). These practices include (i) the non-pro rata allocation of fees and expenses, (ii) limitation or reduction of adviser clawbacks for taxes, (iii) reimbursement of adviser fees and expenses for certain regulatory, compliance, examination and investigation services, and (iv) borrowing or receiving extensions of credit from investors.

Potential Impacts on Use of Side Letters

The SEC’s stated purpose in adopting the New Rules is to provide added protections to private fund investors through increased transparency, competition, and marketplace efficiency. This is a laudable goal.  In adopting the New Rules, the SEC seeks to level the playing field, so to speak, and to accomplish this by permitting private fund advisers to escape certain of the less-desirable prohibitions under the New Rules through extensive disclosure and, in some cases, affirmative investor consent requirements. A “Sunlight is the best antiseptic” approach, if you will. However, the use of so-called side letters by real estate funds and their advisers, in particular, reflect two realities: (i) institutional and UHNWI (Ultra High Net Worth Individual) investors and their financial advisers wield substantial power when it comes to negotiating side letters and other preferential terms with fund advisers; and (ii) the real estate private fund space is extremely competitive and, arguably, more susceptible to market conditions and other “risk factors” than other asset classes.  As a result, the use of side letters has become commonplace and is a practice that is unlikely to diminish even with the SEC’s promulgation of the New Rules.

It should be noted that the exceptions to the New Rules — e.g., the Preference Rule does not apply to an investor that is required to redeem due to applicable laws, rules, regulations or orders of a relevant government authority — will also play an important role in whether a private fund adviser might seek to reconsider its side letter terms and policies. The type of fund — open-end versus closed-end — will also play a role, as the SEC has already acknowledged its position that preferential rights offered to investors in a closed-end fund would have a harder time meeting the “material, negative effect on other investors” standard set forth in the Preference Rule. It is also worth noting that an important item from the draft rules circulated by the SEC for public comment did not make it into the Final Rules: the provisions that sought to define an adviser’s standard of care when utilizing side letters with investors. Unlikely an oversight, this omission of a “harder” rule on the use of side letters was no doubt the result of the SEC’s recognition of the prevalence in the use of such private agreements based on public comment. Also noteworthy, the SEC has stated publicly that the mere disclosure to investors of the fact that other investors are paying lower fees is insufficient. Instead, an adviser must sufficiently describe the lower fee terms to provide the information required under the rule. Alternatively, the adviser could provide copies of the relevant side letters with investor-identity information redacted. The exceptions will undoubtedly occupy an important place in advisers’ (and their counsel’s) minds going forward, so what’s next?

Matters Private Fund Advisers Should Consider

Aside from the logistical challenges presented by the New Rules for private fund advisers, and the debate over whether existing laws and regulations sufficiently limit conflicts of interest, self-dealing, and other questionable practices of advisers that the SEC now seeks to prohibit or further restrict, private fund advisers need to be prepared to respond to the New Rules. At a minimum, advisers will need to take a careful look at what changes need to be made to their offering documents, internal regulatory compliance policies and procedures, and overall investment strategies. Finally, it should be noted that the Preference Rule and Activities Rule require private fund advisers to bring their funds into compliance with the New Rules by the “Compliance Date” — calculated from the publication date of the New Rules in the Federal Register — as follows: (i) for “Large Advisers” ($1.5B+ AUM) — 12 months (September 14, 2024); and (ii) for “Small Advisers” (< $1.5B AUM) — 18 months (March 14, 2025). Certain aspects of the Preference Rule (preference in redemptions and information rights) and Activities Rule (borrowing and charging fees for certain investigations and audits) are not applicable to private fund advisers for funds that have commenced operations prior to the applicable Compliance Date.

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