Browsing by Subject "Contract Modularity"

Private equity contracting has always been an area of corporate contracting well hidden from the snooping eyes of the outside world, and largely overlooked by legal scholars compared to other areas of corporate law. The participants of private equity are some of the most sophisticated and resourceful when it comes to financial innovation and executing transactions. This would lead one to believe that the contracting taking place within private equity is characterized by unrivaled efficiency. This is, however, not the case, and the process is seemingly riddled with inefficiencies and risks for both investors and investment managers. A prime example, and the main focus of this thesis, are side letters – ancillary agreements whereby investors negotiate with investment managers for individual benefits deviating from the general terms granted to all investors in the constitutional agreements of a private equity fund. This thesis sets out to examine the phenomena of side letters in private equity funds in more detail. In doing so, this thesis aims to demonstrate what exactly side letters are, the current nature and extent of their risks and inefficiencies, the contributing factors behind their inception and evolution into what they are today, as well as provide some alternatives for correcting the current market practices. In addition to examining the legal framework and general contract law principles applicable to side letters in the U.S. and the EU, with some specific viewpoints from the Nordic and Finnish jurisdictions, the thesis analyses side letters from the perspective of some modern theories on contracting, rather than contract law. The main ones utilized here are Proactive Law, Contract Modularity and Transaction Cost Economics. Apart from a strict legal dogmatic study, this thesis takes a more practical approach by not only assessing whether side letters can, but also whether and to what extent they should, be used to achieve the goal they set out to do. Side letters are surprisingly unique contracts, with their structure and position within a private equity deal exhibiting a form of complexity that at times creates ambiguities as to their validity, both in terms of individual terms and the side letter as a whole. Their status as modular and ancillary agreements risks resulting in uncertainties as to their interpretation or binding force. The bigger problem, perhaps, lies with the inefficiencies they create in terms of additional costs, time and resources spent to negotiate and uphold them. Together, these aspects make one question the reason behind such a seemingly problematic practice taking root in the first place. The reason behind the current practice seems to be a set of misaligned incentives for investors and investment managers alike, upholding the current market practice despite going against the best interest of both parties and the market overall. As it turns out, the specific governance structure within private equity funds creates the perfect breeding ground for the parties to contract inefficiently. The current market environment has long been tilted towards investment managers, which has given rise to several incentives for them to uphold the status quo. Additionally, as shown in the thesis, investors are likewise subject to problematic incentives upholding the current practice. Investors collectively also currently have a hard time taking any meaningful action in correcting the unfavorable environment, due to the existence of the prisoner’s dilemma deterring them from utilizing their collective power to enact change. The thesis encourages investment managers and investors to review their own practices, look past the misaligned incentives and take action in correcting the market environment in favor of the whole industry. This can be achieved by, for example, shortening and simplifying side letters, and transferring much of their current content to the rest of a private equity fund’s constitutional documents, as well as developing sound reporting and disclosure practices. The thesis also makes the case as to why a successful implementation of efficient contracting processes can create competitive advantages for the first movers adopting the various suggestions and strategies presented herein.