Inside Wall Street’s “Side Letter” Scam

For years, Wall Street firms have inked secret deals to give certain investors preferential treatment. The SEC proposed reforms to regulate these “side letters” — but the industry wants to maintain its ability to enrich some investors at the expense of others.

Private equity, hedge fund, and real estate firms are making secret deals with individual investors, giving them privileges not afforded to others in the same investment funds. (Spencer Platt / Getty Images)

For years, the retirement savings of teachers, firefighters, and other government workers have been funneled by public officials to secretive Wall Street firms that charge high fees in exchange for the false promise of outsized returns. But as the stock market plummets and asset values drop, there are new fears that pensioners will be unable to access their cash, while insiders will be allowed to pull their money out before things get worse.

Now, Wall Street firms and their political allies — including a US senator with substantial private equity holdings — are trying to stop federal regulators from intervening to protect retirees by banning firms from giving some investors preferential treatment. And there are no rules requiring lawmakers with investments in private equity to disclose whether they are being given special investment preferences while they lobby to protect those asset managers.

The new battle revolves around the secret “side letters” that private equity, hedge fund, and real estate firms ink with individual investors, giving them privileges not afforded to others in the same investment funds.

In disclosure documents reviewed by the Lever, many firms managing millions of workers’ retirement savings say they can give certain well-connected investors or family members lower fees than other investors. Regulators say those letters can also give well-connected investors special rights to withdraw their money — rights that may not be given to the pension funds of government workers.

After years of complaints by retiree groups, the Securities and Exchange Commission (SEC) proposed new rules to crack down on the practice, noting that “preferential terms do not necessarily benefit the fund or other investors that are not party to the side letter agreement and, at times, we believe these terms can have a material, negative effect on other investors.”

The SEC is now proposing two specific reforms: side letters would now have to be disclosed to all investors, and firms would no longer be permitted to ink side letters giving confidential information to some investors or allowing some investors to get their money out when they need it and not others.

SEC chair Gary Gensler’s proposed reforms have drawn aggressive pushback from investment firms making big fees off pension systems. Pension funds are sometimes referred to on Wall Street as “dumb money,” because their overseers don’t negotiate the same sort of tough investment terms for retirees that individual billionaires often negotiate for themselves.

In all, private equity, real estate, and hedge funds managing billions of dollars of government workers’ savings have dumped at least $14 million on federal lobbying efforts in 2022 alone, according to data collected by OpenSecrets. The asset management industry is so committed to keeping side letters secret, their lobbyists have successfully fought for special exemptions from state public records laws around the country, so that pensioners and news organizations cannot see the terms of public investments.

By fighting the new federal rules, the industry is hoping to maintain its ability to enrich some investors at the expense of others — a practice that helps them reward their friends, whoever they may be.

“In These Funds, Every Investor Can Be Treated Differently”

When the average investor buys a share of a stock on a public stock exchange, they are assured they get the same rights as any other buyer of the same stock. But the open secret on Wall Street is that outside the public markets, private “alternative investment” firms that manage government workers’ pension savings can treat certain investors — usually insiders like company allies and relatives — better than others.

It is a system that critics say allows financial managers to pick winners and losers among their own investors, and use public pension money to effectively subsidize the gains of more sophisticated, politically connected investors. These financial giants say in regulatory filings that they can make such decisions based on everything from familial connections to political considerations to sheer self-interest.

“I have encountered side letters that I have forwarded to the SEC which stated that the manager of the fund agreed to waive fees to this particular investor as long as he stayed in the fund and promised not to tell anyone about fraud involving the fund. It’s conspiracy to commit fraud,” said Edward Siedle, a former SEC attorney who currently specializes in SEC whistleblower cases. “The point is anything can be in these side letters. They can give one investor certain liquidity rights that other investors don’t have. They can give knowledge of portfolio positions that other investors don’t have. They can give different fees. Unlike mutual funds where every investor is treated equally, in these funds, every investor can be treated differently.”

Federal filings reviewed by the Lever suggest that many alternative investment managers routinely give themselves wide latitude to favor one investor over another.

For instance: private equity firm Thoma Bravo, which manages $114 billion of investor money, says in its federal disclosures that it will use side letters as it pleases: “Thoma Bravo is likely to have its own economic and/or other business incentives to provide certain terms to certain limited partners . . . or the potential to establish, recognize, strengthen, or cultivate relationships that have the potential to provide longer-term benefits to Thoma Bravo, its affiliates, and personnel.”

Similarly, Grosvenor Capital Management — which manages money for California’s massive public pension fund — says the firm enters into side letters with certain investors that “have the effect of establishing rights under, altering, waiving, or supplementing” existing agreements “in a manner more favorable to such investors than those applicable to other investors.” The disclosure declares that “there can be no assurance that any such arrangements will not have an adverse effect” on investors who do not get the preferences.

A filing made by Apollo Global Management, which has $512 billion under management and manages public pension money, states that the firm will enter into side letters “for any reason it deems necessary, advisable, desirable, or convenient. As a result, returns could vary from limited partner to limited partner depending on any arrangements applicable to a given limited partner’s investment in the client. The general partner will not be obligated to offer or disclose such terms to any other limited partner.”

In other words, Apollo has the ability to enter into side letter agreements at any time for any reason and does not need to disclose the matter to any other investor in the fund, even if the agreements materially harm people — such as by allocating expenses for private jet rides and “portfolio monitoring fees” to some investors and not others.

The Carlyle Group, which has $369 billion assets under management, said in a federal filing this summer that it negotiates side letters with investors that contain “fee and other economic arrangements with respect to such investor,” and “additional or modified reporting obligation[s].” The latter practice allows managers to give their favored investors expanded access to information that other investors lack.

Blackstone Management Partners, a Blackstone Group entity that manages $95 billion in private investment accounts in energy, quietly spells out its side letter policy in a filing where it describes “Blackstone Strategic Relationships.”

In that document, the company says it can bring in a new investor, offer them preferential fees and benefits, and provide them with a disproportionate share of investment profits. The filings also state that Blackstone never has to disclose any of these actions to other investors.

“Preferred Liquidity Terms”

Concerns about secret side letters and pensioners’ ability to get their money back are now acute as the stock market has dropped and institutional investors have braced for private equity, real estate, and hedge funds to reduce the stated value of their assets. Some of those investors have started trying to liquidate their holdings, selling off nearly a quarter of a trillion dollars in existing private equity stakes to other investors.

But if those pension funds try to demand their money back from those firms in order to pay benefits to teachers, firefighters, and other government workers, they may be rejected by firms that have signed side letters giving some investors special withdrawal and liquidation rights not afforded to others.

“We understand that some private fund advisers grant one or more investors more favorable redemption rights,” the SEC said in its comments to the proposed rule, summarizing their justifications for cracking down on the practice. The SEC pointed to a 2013 case where it prosecuted a private equity firm for granting better terms for withdrawing money to some investors and failed to disclose that to the firm’s board of directors and other investors in the fund.

Many pension systems may not even know that other investors in the same funds have received special preferences — which is exactly why federal regulators say they are pushing new transparency rules governing side letters.

As Gensler put it in a November speech, such side letters “can create preferred liquidity terms or disclosures. This can create an uneven playing field among limited partners based upon those negotiated terms.”

In response to such arguments, a Blackstone real estate fund warned that federal regulators’ proposal to regulate special preferences could harm investors already receiving special benefits not given to other investors.

“These [SEC] amendments could impose limitations regarding preferential treatment of investors in private funds,” the company wrote in a filing, adding that the firm “could potentially be prohibited from complying with certain side letter provisions and thereby deprive Investors of the previously negotiated benefits of such agreements.”

“Murky and Broad Anti-Fraud Provisions”

As minimal and limited as it is, the SEC’s proposal to better regulate side letters has faced a furious opposition campaign from lobbyists and from lawmakers who have raised big money from the private equity industry.

In the months since the SEC filed its rule, the agency has been flooded with letters from lobby groups like the Managed Funds Association (which represents hedge funds), the American Investment Council (which represents private equity), and a series of public pension funds all urging that the proposed rules be toned down or withdrawn.

Similarly, as Democrats were raking in more than $34 million of campaign cash from private equity and investment firms, a dozen Senate Democrats sent a letter to Gensler demanding that the SEC slow down its rulemaking process by extending comment periods, a position that was earlier pled in a bipartisan House letter in April, and later echoed by a group of Republican state attorneys general at the end of October.

Then came explicit demands to outright kill the SEC’s initiative from Sen. Bill Hagerty (R-TN), whose letter pressuring regulators did not mention that he has a personal financial stake in the private equity industry that has been lobbying against those same rules.

In that December 12 missive written with Sen. Tim Scott (R-SC), Hagerty asserted that Gensler’s proposed reforms rely “on murky and broad anti-fraud provisions.”

The two continued, “Additionally, the SEC’s delegated power does not extend to retroactive regulation. As drafted, the proposal would apply to current, negotiated contracts between highly sophisticated parties that raise questions of due process.”

In other words, the senators believe the SEC cannot regulate existing side letters that allow managers to give out preferences to their friends, to the detriment of regular investors.

Among the biggest campaign contributors to Scott and Hagerty are donors from alternative investment firms, according to OpenSecrets.

Hagerty, a former private equity executive, had between $3 million and $9 million invested in private equity and private equity–owned firms last year, according to a Lever review of his personal financial disclosure.

Among other holdings, Hagerty has invested as much as $1 million in what appears to be a Goldman Sachs–affiliated investment vehicle, identified in filings as “Princeton Fund LLC,” based in New York. According to the alternative investment analysis group Pitchbook, Princeton Fund is a Goldman Sachs Asset Management fund.

In a federal filing, Goldman Sachs Asset Management states that it “enters into confidential side letters or similar agreements or other arrangements with certain investors, without the approval or vote of any other investor, that amend, modify or supplement the economic, legal or other terms applicable to those investors.”

The filing notes that Goldman will use “criteria [it] considers reasonable in its discretion” to determine who receives such side letters, and that these agreements can involve “withdrawal rights from the investment vehicle.”

“Hagerty is not only trying to prevent the SEC from casting light on side letters, he’s acting in a subject area in which he has a financial conflict of interest,” said Craig Holman, government affairs lobbyist at watchdog group Public Citizen. “Since Hagerty’s financial interests will be affected by this rulemaking, he should either divest of the conflict or recuse himself from the matter altogether.”

Additional pushback on the side letter provision came from Rep. French Hill (R-AR), who holds more than $100,000 in Blackstone Group stock.

While congressional ethics rules require Hagerty and other lawmakers to disclose their investment holdings, they do not require them to publicly disclose the specific terms of those investments, or whether they have received side letters giving them special preferences that have not been afforded to other investors in the same investment vehicles.

Neither Hagerty nor Goldman Sachs responded to the Lever’s questions about whether the Tennessee lawmaker has been given a side letter as he helps the alternative investment industry pressure lawmakers to kill transparency rules.

Hagerty’s pressure amplifies similar pushback from the broader private equity industry.

For example: the American Investment Council, the top lobbying group for private equity, is also fighting the reforms, noting in a June comment letter that the SEC’s proposals on side letters “reflect basic misconceptions about the operation of private funds, and, as a result, threaten the unintended consequence of making it substantially more difficult for [pensions and other investors] to invest in private funds.”

The group’s comment also alluded to the fact that some pension funds negotiate side letters to remedy some of the most egregious language in contracts with alternative investment firms, like waivers of fiduciary duty, which eliminate the requirement of money managers to act in the best interest of investors.

Because some pension funds negotiate terms that comply with the law and best practices, according to the lobby group, that means all side letters must be protected.

Notably, the proposed rules also face resistance from pension funds such as the Ontario Public Service Employees Union Trust in Canada, as well as from inside the SEC itself. Reporting in the trade press suggests that the industry’s pressure campaign may be working, with Buyouts Insider reporting earlier this month: “Aides to SEC Chairman Gary Gensler have told private fund reform advocates to dial back their expectations so the chairman can focus on [environmental, social, and governance] and market structure proposals.”

All the lobbying has already resulted in one key win for the industry: a line slipped into Congress’s end-of-year omnibus spending bill.

That unrelated spending legislation currently states that Congress “strongly encourages the SEC to reconduct the economic analysis for the [side letter rule] to ensure the analysis adequately considers the disparate impact on emerging minority and women-owned asset management firms, minority and women-owned businesses, and historically underinvested communities.”

Such a provision, if successful, could further delay the rule’s implementation.