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A standard feature of the private equity industry, “side letters” are confidential agreements between the sponsor and individual investors that give the latter special rights, beyond those that apply to other investors in the private equity fund. Yet side letters have become a flashpoint for prominent critics of the industry, who argue that they allow private equity sponsors to benefit their favored investors at the expense of smaller, less sophisticated ones. Others have argued that, to the contrary, side letters are merely an efficient means of price discrimination—charging different prices to different investors, according to their willingness to pay—a practice that is common and well accepted in other industries.

We find fault with both views. We provide the first empirical analysis of side letters, which disproves some of the most common claims about their content. Specifically, we code the terms of each side letter in a hand-collected sample from thirty years of buyout funds. Contrary to the conventional wisdom, we find that side letters very rarely grant fee discounts to investors or otherwise reallocate the fund economics among investors. Instead, side letters are mostly designed to accommodate a fund investor’s regulatory and tax concerns. The view shared by both critics and proponents—that side letters are primarily used to treat investors differentially—is largely mistaken.

Side letters remain problematic, but for very different reasons than those raised by critics. We show that side letters have grown substantially in both length and complexity over time. They impose significant costs and delay on private equity capital-raising, and they potentially impinge on funds’ operations and investments in unexpected ways. Over time, they have prompted an inefficient arms race among investors, leading to ever longer negotiations and more complex contractual networks for private equity funds, with little benefit for investors or sponsors. Using qualitative interviews with key participants in the industry, we explore the causes, including lawyer agency costs and other contracting frictions.

This Article makes three key contributions to the literature. First, using a first-of-its-kind, hand-collected and hand-coded dataset of side letters, it provides much-needed insight into one of the most guarded industries in the U.S. economy. Second, in contrast to the prevailing view in the contract modularity literature, the Article provides a cautionary tale regarding “over-modularity” and its costs. Finally, the Article offers several timely policy recommendations, arguing that, paradoxically, the current inefficient bargaining equilibrium is likely due to the relative lack of regulation of private equity funds. The industry would be better served with either regulation or coordinated industry action focused not on imposing uniform fund economics, but on ensuring more standardized documentation across investors and funds.

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