Shadow Contracts

Abstract

This project explores side letters in private market funds. Side letters, separate agreements between a fund and an investor, act as an invisible amendment to the main contract. This article introduces a new use case for side letters: impact investments, where funds target social, as well as financial returns. Using a hand-collected data set, we examine the scope and role of side letters in this growing space. Side letters as “shadow contracts” demonstrate the Easterbrook/Fischel theories in action, namely that parties “write their own tickets,” tailoring agreement terms to their specific needs within the framework of corporate governance rules. Expressing preferences and constricting manager power through contracts is even more important when managers serve dual goals. However, side letters come with costs, including direct transactional fees and indirect costs such as additional complexity, slower adoption of best practices, and hidden hierarchies that advantage some parties to the detriment of others. The solution? Standardization and transparency. Common side letter provisions, such as information rights and advisory committees, should be addressed in the main agreement to reduce costs, increase transparency, and push contract innovations out of the shadows. Further, in line with recent SEC proposed rules, side letters should be disclosed.

Keywords: private funds, side letters, impact investing, standardization, law and economics, contracts, deals