June 13, 2023
Funds are turning to modern software to help them stay on top of their side letter compliance and reporting. Learn about the tools built for the task.
June 13, 2023
It’s clear that one of the biggest challenges facing asset managers is compliance, regulatory requirements and the various obligations that must be met in order to avoid significant sanctions.
Not only is there consistently increasing scrutiny from the SEC and other relevant organisations, but funds also have a duty to regularly report to institutional investors on a monthly, quarterly and yearly basis.
The risks of non-compliance and missed reporting deadlines are too great to ignore, yet there are certain barriers, in this instance side letters, that prevent asset managers from achieving this.
Side letters are created to secure special rights for individual investors outside of the limited partnership agreement (LPA) which applies to all of a fund’s investors. The provisions included in side letters are designed to grant investors certain exemptions, immunities or preferential treatment usually related to fee discounts or their regulatory and tax concerns.
These could be relevant to a variety of aspects, such as:
Other potential side letter clauses may include securing seats on a fund’s advisory committee, registering interest in co-investment opportunities, or utilising a most favoured nation (MFN) provision to guarantee that they’re also able to obtain any favourable preferences awarded to other investors from their respective side letters.
A recent development that has further increased the scope of terms in the side letter space is the inclusion of Environmental, Social, and Governance (ESG) provisions. With each limited partner (LP) accountable to their respective stakeholders and jurisdictions, they all bring their own ESG mandates to the table, and their lack of inclusion in the majority of LPAs means that side letters are burdened with the responsibility of meeting these highly-individualised mandates.
The concept of side letters isn’t new to the asset management industry, with a history dating back to the late 1980s and the rise of private equity funds. However, their growing prevalence, particularly since the financial crisis of the late 2000s, has led to a series of new legal challenges for asset managers that are becoming increasingly impossible to solve with traditional methods.
As the volume of side letters has grown over the last decade and a half, so too has their complexity. This issue is highlighted by Elisabeth de Fontenay and Yaron Nili in their recent academic paper Side Letter Governance, explaining that the average word count of side letters has risen from 639 (pre-2005) to 4,983 (post-2014).
With this astronomical rise in word counts subsequently taking the average page count from 1.3 (pre-2005) to 8.5 (post-2014), it’s evident that for asset managers, the critical task of managing side letters to stay compliant is edging further out of their control.
As they’re becoming a more significant part of fundraising exercises, side letters are also affording investors greater negotiation power.
Whilst it’s obviously beneficial to secure the kind of large-scale financing that side letters often facilitate, the varying nature and increasing scope of their terms means it’s essentially impossible for just one person within a fund to monitor and manage them. Side letters require specialised knowledge from a multitude of individuals/internal teams across a fund, who now have to commit time to managing them rather than working on higher-value activities like deal-sourcing.
Equally, managing side letters manually can be expensive, slow and unreliable. This is made only more difficult by an over-reliance on outdated operational processes such as using Excel, physical documentation and complex centralised document servers.
Without the right tools, processes and software in place to assist with side letter management, it’s easy to miss a critical deadline or obligation and face severe ramifications for doing so.
Given the looming threat of tougher SEC scrutiny coupled with the growing volume and complexity of side letters, it’s clear that asset managers now require something purpose-built to manage their vast amounts of contract data in order to avoid punishment.
Query stores all of an organisation’s signed contracts inside a powerful, searchable contract repository. It provides users with a single source of truth, enabling anyone within an organisation to locate critical data with just a few clicks.
A tool like this is essential for asset managers to achieve sufficient oversight of their contract data, using AI-driven labels to identify contract provisions with a high level of accuracy and facilitating rapid generation of detailed reports.
It’s crucially important that funds know what clauses are in side letters, the most common wordings of those clauses (the ‘standard’ version), and how other wordings of that clause differ from the ‘standard’ version.
In short, legal teams want to be able to compare the different wordings of a clause. However, this is incredibly time-consuming when done manually across all of their agreements and is considered low-value legal work, despite being critical to managing obligations.
Within Query, there is clause compare functionality, which allows users to quickly surface the most common wordings for specific clauses in their contracts, and then compare all of the different wordings against each other. This saves legal teams potentially hundreds of hours of manual work and ensures obligations are never missed.
Our software can help with a variety of investor obligations, including facilitating the MFN election when new investors come on board.
Once clauses are identified, side letters can be created and stored in Query, which also makes them much easier to find when required.
In terms of staying compliant and meeting regulatory requirements in relation to side letters, Query has one other crucially important feature: reminders.
Query users can set reminders for key information contained in contract clauses by selecting the labelled clause which they need reminding about, based off an event date relevant to when they need reminding.
When doing this, users can also set specific timings either before, on or even after the event date for when they’d like to be reminded, where they will receive a dedicated email reminder at 8:00am GMT/08:00 UTC on that day. There’s also the option for repeat reminders, which is particularly useful for managing regular reporting deadlines (i.e. monthly, quarterly, yearly), to share important updates with investors regarding aspects like ESG and financial developments.
Reminders are sent to pre-selected recipients on the required date, where they’re then automatically taken to the relevant clause and can see any appropriate actions they need to take.
Not only does this eliminate the risk of missed deadlines or obligations and shield users from potential SEC sanctions, it also means that all investor commitments are met, strengthening investor relationships whilst greatly reducing the administrative burden of side letter management.
Where a commonly-used tool such as SharePoint can store contracts and their data, it isn’t tailored to legal processes, meaning locating important provisions and producing reports is a manual, time-consuming task.
However, unlike SharePoint, Query is specifically built for the legal use case.
In Query, AI automatically identifies any relevant provisions and makes them searchable in a database, so you can find the contracts you’re looking for in a matter of seconds then generate reports of key provisions, rights or obligations with just a few clicks.
Though on the surface CLM software packages appears the obvious solution to side letter management, the additional challenges they create, particularly when compared with modular software, are significant.
CLM implementations are a notoriously complex undertaking, requiring considerable time, money and internal resources to buy, deploy and maintain them. Robin AI’s lightweight, cost-effective modular approach removes such complexities whilst providing the same comprehensive functionality required to manage obligations and users benefit from speedy onboarding aided by specialist legal and technical teams.
Evidently, side letters are both a current and growing concern for asset managers. With their increasing volume, complexity and varying terms, traditional manual methods of managing them are now simply outdated. Funds require a modern, efficient technological solution to assist them if they’re to stay on top of compliance, reporting and regulatory commitments.
So, for asset managers who require maximum oversight of contracts and their data, reminders to ensure they never miss a deadline and who ultimately want to keep the SEC and their investors happy, the first step is to consider investing in specialist software purpose-built for tough challenges like side letter management.