Last fall, Wharton Social Impact Initiative announced a collaborative project with Penn Law’s Entrepreneurship Legal Clinic. Our Social Impact Fellowship legal research team—composed of Anne Tucker, an associate professor of law at Georgia State University, and four Penn Law students—collected and analyzed data to better understand how impact investing funds reflect their social impact agendas in their legal agreements.
This week we will publish a series of blog posts from these students, reflecting on their experience and what we’ve learned thus far. In this post, Meka Osawamoto Jegede dives deeper into the impact investing research conducted by Wharton Social Impact fellows this year.
Side Letters vs Limited Partnership Agreements: A Question of Trust?
It’s fair to say that, in addition to traditional duties, an impact fund manager must also keep the fund ‘on mission’ and ensure the particular status (tax, nonprofit etc.) of each investor is not compromised.
Our research revealed that mission protection clauses were fairly common in portfolio level documents via “use of proceeds” clauses, internal and external social impact reporting and/or the powers granted to advisory committees. By contrast, social impact was mentioned only broadly or not at all in Limited Partnership Agreements (“LPAs”). LPAs tended to focus on financial issues rather than mission. Instead, impact investors rely heavily on side letters—a type of collective bargaining agreement—to address these concerns.
The LPA may build the investment vehicle, but it’s side letters that give impact investors the opportunity to steer.
The tricky part is that no one is quite sure if and how side letters can be enforced, which raises a number of questions.
What happens if there is tension between the LPA and the side letter?
Another LPA feature is what one could call “no favoured nation” clauses, which allow fund managers to ignore the investors’ individual circumstances when making investment decisions.
Well, then what’s the point of executing a side letter if the fund manager can simply ignore it when convenient?
In traditional private equity, the answer is disclosure. In Europe, the Alternative Investments Fund Manager Directive requires pre-investment disclosure of even the possibility of side letters. The SEC has a similar rule based on fiduciary obligations. Where the disclosure box is ticked, the side letter overrides the LPA.
For our purposes, these answers raise even more questions.
Where does an impact fund outside of Europe/US look for guidance? What happens when the side letter imposes non-disclosure clauses on the General Partner (GP)?
One answer is that none of this really matters, as it’s really all about clout, not contract. The largest LP’s side letter always wins. This makes sense: if a major impact investor pulls out, the entire fund may collapse. Another answer (which has popped up in our research) is to include disclaimers in side letters limiting a fund manager’s obligations to ‘best efforts’.
But this solution leaves the minority investor with two difficult options; gather enough LP support to oust the fund manager or litigation. Litigation brings us back to enforceability, and gathering a consortium [of limited partners/investors?] costs time and effort.
Further, these answers are not entirely compatible with the peculiarity of impact funds. Save for a few big players – large foundations, international investment corporations, impact consortiums- impact investors rarely have a majority stake in impact funds. How then do all these Davids beat Goliath?
Perhaps the dual functions of side letters – mission and regulatory protection- should simply be captured in the LPA. Investors who are unhappy with this arrangement can still enter into “full” side letters, but this would be at their own risk.
For this approach to succeed, the fund manager must trust its investors not to kick out at the first sign of (necessary) mission deviation, and the investors must trust the fund manager not to unreasonably go off course or renege on the side letter. This is not a huge leap from the current side letter/LPA regime, but could provide greater clarity. Plus, impact investors or fund managers could use due diligence and marketing materials to assemble a consortium with shared or similar mission and regulatory concerns to minimize the moral hazard risk from the very beginning.
The legal status of side letters may be a grey area but perhaps we are understating their normative power in impact investing; in a space where investors are trying to make the world better, perhaps it really is just a matter of trusting your partners to do their best.
Meka Osawamoto Jegede is a dually qualified barrister in the U.K. and Nigeria. She is currently an LLM and Wharton Business Law Certificate Candidate at Penn Law and the Wharton School. Meka obtained an M.A in Jurisprudence from the University of Oxford in 2007 and was called to the Bar of England and Wales in 2008. From 2008-2009, she interned at UNESCO whilst also studying French at the Sorbonne before returning to London to practice commercial law at Henderson Chambers and 4 New Square. She also earned a BL from the Nigerian Law School and was called to the Nigerian Bar in 2014. Thereafter, she worked as a Senior Associate and In-House Counsel at the Asset Management Corporation of Nigeria. Outside of work, Meka is interested in long distance running, social impact advocacy and travel.