Private Funds Under Pressure
Solving the Investor Side Letter Challenge with Contract AI Technology
Private fund advisers were relieved in June 2024 when the U.S. Court of Appeals for the Fifth Circuit vacated all of the SEC’s new private fund adviser rules less than a year after they were announced in August 2023. These rules would have enhanced regulation, required increased transparency, and in some cases, restricted the preferential treatment of investors, creating new compliance challenges for advisers (as discussed in our prior blog on this topic).
In the months before the SEC rules were vacated, private fund advisers began focusing on their investor side letters and many realized that their processes for tracking obligations and other important provisions were manual, inefficient, and contained “holes” with some obligations not being tracked at all. This has sustained the pressure on private funds and underscored an urgent need for better solutions to manage growing complexity.
Understanding the Operational Challenges and Pain Points
Investor side letters and certain other documents often grant specific rights and privileges to select investors, such as:
- Strategic, early, or large investors (e.g., seed capital providers or significant fund contributors),
- Regulated or sovereign investors (e.g., ERISA, BHCA, or state pension systems), or
- Insiders (e.g., employees, friends, and family)
Investor side letters pose operational challenges and are painful to deal with:
- Little standardization of investor side letters: While private fund advisers try to impose their form of side letter, many investors are able to negotiate bespoke terms (often necessary for the investor’s own compliance in a highly regulated environment) so there is little standardization of provisions across side letters
- Burdensome to manage: Many provisions require actions by the private fund adviser so they come with a burden of active management, such as:
- requirements to provide notifications or take other actions following the occurrence of particular events
- requirements to report on performance, risk and valuation at prescribed frequency
- requirements to comply with certain regulations that apply to the investor and prohibitions from doing certain things all impose an additional compliance burden; and
- providing certain rights to the investor such most favored nation treatment
- Regulators are interested: While the SEC’s regulations were vacated, the SEC and other regulators are still interested in side letters, preferences granted under them and how private fund advisers manage these and their other obligations.
- Investors are interested: Investors usually ask the private fund adviser what terms they have granted other investors in their side letters when undertaking their diligence before their investment and periodically thereafter.
- Reputational implications of breach: Private fund advisers cannot afford the reputational red flag that can arise from any litigation resulting from breach of the terms of an investor side letter. Investors can be skittish, and any reputational red flag can affect their decisions on initially investing or maintaining an investment.
How Contract Review Software Can Help Private Fund Advisers
Fund advisers cannot continue to rely on traditional manual processes for document reviews. Today’s environment demands scalable, precise, and proactive solutions.
AI-driven contract review software like Catylex transforms how private fund advisers manage their obligations and delivers:
- Streamlined Analysis: Quickly identify obligations and other requirements to determine:
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- Actions required
- Triggering events, timing and frequency for those actions must occur
- Extent of reporting and disclosures required
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- Unparalleled Efficiency: Manually reviewing hundreds of complex documents ties up internal resources or requires costly external help. Catylex slashes the time spent on reviews by over 60%, enabling teams to reallocate resources to high-value tasks.
- Accuracy That Builds Trust: Legal documents brim with nuance. As one fund lawyer noted, “The machine is more consistent than my team. And when it errs, it’s quick to correct—and it won’t repeat the mistake.”
- Risk Mitigation: By automating reviews, fund managers avoid oversights that could lead to compliance failures, investor dissatisfaction, or financial penalties.
A contract review software solution like Catylex can be a game changer. Catylex leverages AI technology to analyze agreement provisions swiftly and accurately. Catylex combines various approaches to eliminate the risk of AI hallucination and ensure the solution can scale. Catylex has an extensive data model for investor side letters developed by people with experience in this field and tested through use by asset managers and service providers.
Want to see a detailed demonstration of how Catylex can analyze your investor side letters? Let us help you stay ahead of the curve. Contact us.