“Granting preferential transparency, for example through side letters, presents a sales practice that is contrary to the public interest and protection of investors,” the Securities and Exchange Commission said in February.

The SEC has proposed restrictions on side letters accompanying private funds’ limited partnership agreements. These include prohibiting side letter terms that create “preferential transparency” – reporting commitments by the GP to certain LPs about fund performance and holdings – and implementing disclosure requirements for other side letter terms. These form part of a wider proposal to foster more alignment and transparency between investors on fees, expenses and performance metrics. So far, so laudable.

The Los Angeles County Employees Retirement Association, however, fears that prohibiting “preferential transparency” side letter clauses will inhibit LACERA’s efforts to foster sustainable practices within its private markets portfolio. Chief investment officer Jonathan Grabel, writing to the SEC, said LACERA uses side letters to require managers to report on the fund’s ESG and DEI progress and performance. “Side letters are a crucial means for market innovation. Investors have limited tools to advance market practices. Side letters are key – if not the most powerful – among them.”

The SEC’s concern is that side letters can exacerbate power imbalances between LPs, piling privileges on the most powerful – and often largest – investors.

With assets worth $73 billion, LACERA could certainly be considered one such powerful investor. It is not alone in using its weight in this way. “A lot of LPs are using side letters to push managers on ESG,” Mary Beth Houlihan, partner in Kirkland & Ellis’s ESG and impact department, tells New Private Markets. These can go beyond LACERA’s focus on ESG reporting to active ESG measures; Houlihan reports seeing examples of LPs requesting GPs sign up to the UN’s Principles for Responsible Investment or adopt certain ESG policies in side letters. An LP survey last year by placement agent Capstone Partners found 29 percent of surveyed LPs ask for opt-out clauses in side letters for ESG reasons. What happens if these side letter clauses are prohibited? The obvious answer is they find their way into LPAs, affording all LPs the same level of transparency.

This, however, gives rise to an alignment problem. When it comes to ESG in 2022, the LP universe is heterogeneous; investors differ on their priority areas, how they want data reported, and in many cases on the relevance of “extra-financial” data. Some are actively opposed to it.

Moreover, ESG reporting is costly. Says Kirkland & Ellis’s Houlihan: “You don’t necessarily need to have all LPs bearing the cost of that reporting when it’s really only a select few LPs that need it.” US investors probably won’t want to pay for EU SFDR reporting.

Forcing ESG measures and reporting requests out of side letters and into LPAs could cause friction among investors. I fear many such requests would be dropped altogether.