By Niamh Cheung, Client Services Director, Funds
In the current macroeconomic environment, private equity firms are experiencing a significant shift in the balance of power between Limited Partners (LPs) and General Partners (GPs).
This change has led to a rise in the use of side letters and separately managed accounts (SMAs), each of which presents distinct challenges and opportunities for Chief Financial Officers (CFOs) and Chief Operating Officers (COOs) within these firms.
The relative abundance of capital within sovereign wealth funds (SWF) constituencies gives them significant negotiating leverage. As a result, we’ve seen an increase in the frequency of side letter requests from SWFs, especially in the Gulf Cooperation Council (GCC) region.
In this article, we’ll discuss the impact of both side letters and SMAs for private equity CFOs.
1. The increased use of side letters
Side letters are agreements between private equity funds and specific investors which are supplemental to the standard terms of the main legal documents of the partnership, granting these investors more favourable terms and rights than those offered to other investors.
Regulators over the years have made it clear that although there is no restriction on the use of side letters, there is a requirement for transparency. It’s generally accepted that the terms of any side letter shouldn’t attempt to contradict the terms of an LPA or give preferential treatment to individual investors.
There has been a notable increase in side letter usage since the SEC’s private funds rules were made defunct. This deregulation has allowed LPs to leverage their enhanced negotiating power to secure more customised terms.
2. The rise in SMAs
SMAs are investment structures where a single investor collaborates with a fund manager to create a tailored investment portfolio.
The proliferation of side letters and SMAs significantly impacts the administrative and back-office functions of private equity firms. CFOs and COOs must handle a higher volume of customised terms and complex reporting requirements, which strains existing administrative systems and necessitates advanced tracking capabilities. Similarly, SMAs, while offering benefits such as tailored investment strategies and better alignment with investor goals, impose additional burdens in terms of reporting and compliance.
To manage these challenges effectively, CFOs and COOs may consider outsourcing certain functions to alleviate the administrative load, though it’s crucial to ensure that these outsourced services align with the firm’s strategic goals and regulatory requirement.
Key considerations for CFOs
- Timing and cost implications: The negotiation of side letter terms can cause significant delay to the onboarding of LPs due to the vast number of topics and requests from different investors and in turn can increase the legal costs associated with each closing. It’s important to set out a side letter strategy, defining the potential scope of side letter terms, outlining the expected costs associated with side letter terms in practice and eligibility of LPs
- Implementing global best practice: Side letter terms can be an excellent way to build investor confidence and close out investor specific terms in order to expediate the onboarding process. However, when considering the topics and requests from LPs, it’s an excellent opportunity to consider integrating some of the terms into the governing legal documents of the partnership. Therefore, allowing for the evolution of the fund manager’s own best practice and improving the investor experience for all parties while also reducing the administrative time in monitoring individual investor clauses
- Enhanced administrative capabilities: Administrative challenges often arise with side letters, demanding considerable time and attention from a fund manager. Over the course of a fund’s life, the manager must track the provisions granted in these side letters, monitor compliance with them, and ensure that the terms of one limited partner’s side letter do not conflict with the terms of any other side letter, the partnership agreement, the subscription agreement, or any other governing document. To manage the increased complexity of side letters and SMAs, it’s crucial to invest in advanced systems and processes, including robust tracking and comprehensive reporting tools
- Outsourcing solutions: Explore outsourcing options for administrative functions to alleviate the operational burden. Choose partners with expertise in private equity to ensure alignment with strategic goals and regulatory requirements
- Generative artificial intelligence (AI) and robotic process automation (RPA): CFOs should consider the benefit of automation and AI, in both the summary of side letters terms for quick reference, in addition to the tracking and monitoring of these arrangements over time. This can create efficiencies to reduce the administrative burden. Generative AI can improve the availability of enhanced reporting that so often is at the centre of side letter terms as more and more LPs become data centric
In summary, the rise in side letters and SMAs presents both opportunities and challenges for private equity CFOs. By enhancing administrative capabilities, considering strategic outsourcing, and strengthening LP relationships. CFOs can effectively manage these changes and support their firm’s success in a dynamic investment landscape.
If you’re interested in learning more about our CFO support services, contact us today.
About the author
Niamh is a Client Services Director, Funds, based in Belfast. She has 20 years’ industry experience, with expertise in client management, business pitches, team delivery, resourcing and accounting services.
