LACERA opposes SEC’s proposed side letter restrictions on ESG and diversity grounds

The Los Angeles County Employees Retirement Association is opposed to recommended side letter restrictions on the grounds that it will inhibit ESG and diversity reporting in private markets.

Earlier this year, the US’s Securities and Exchange Commission proposed a rule restricting the use of side letters in limited partner agreements and requiring fund managers to disclose the fees and expenses they charge to LPs.

In a letter LACERA sent to the SEC – a copy of which is included in materials accompanying the $73 billion pension fund’s investment board meeting scheduled for 10 August 2022 – chief investment officer Jonathan Grabel says LACERA supports the fee disclosure clauses of the proposed rule. However, the letter continues: “We are opposed to the proposed rule’s provisions that may limit investors’ ability to negotiate side letters to limited partner agreements.

“LACERA routinely procures side letters requiring general partners to report on talent management policies and practices pertaining to inclusion, diversity, and equity. We secure side letters prompting private fund advisers to report how they identify and integrate financially material environmental, social, and governance factors (ESG) in the investment mandate. Our side letters do not prescribe practices, but rather prompt reporting to evaluate the general partner’s practices and investment process. Side letters, in effect, constructively advance reporting on evolving market practices, thereby promoting greater transparency to investors. 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 proposal characterises side letters as “grant[ing] more favourable rights and privileges to certain preferred investors”. These types of “preferential treatment”, the SEC says, “do not necessarily benefit the fund or other investors that are not party to the side letter agreement and, at times, can have a material, negative effect on other investors”.

The SEC has proposed to prohibit side letter terms that provide “preferential transparency” and other forms of preferential treatment where the fund manager “reasonably expects that providing the information would have a material, negative effect on other investors” – such as excuse rights allowing investors to opt out of deals that do not meet the certain ESG standards.

“Granting preferential transparency, for example through side letters, presents a sales practice that is contrary to the public interest and protection of investors because it preferences one investor at the expense of another. The proposed rule is designed to neutralize the potential for private fund advisers to treat portfolio holdings information as a commodity to be used to gain or maintain favour with particular investors,” the SEC’s proposal says. The SEC has also proposed disclosure requirements for side letter terms that do not negatively affect other LPs.