The Side Letter

How do private fund managers and certain of their investors arrange for bespoke rights unavailable to the rest of the investor base?

Like the post on carried interest, this topic is way past due. Thank you to the readers who suggested that we discuss it.

We talk today about the side letter.

And side letters are sometimes more important than even the limited partnership agreement (LPA).

To hone your understanding in the first instance, consider looking at the side letter through the analogy of the US Constitution and its relationship to the Bill of Rights, which comprise the first ten amendments to the Constitution: freedom of speech, freedom from unwarranted searches and seizures, due process, etc.

If the Constitution is the primary contract governing the terms and conditions between the federal government and the American people, the Bill of Rights add and perfect certain and special additional rights that clarify, enhance, restrict, or enable the particulars of that relationship.

Think of the LPA as the fund’s constitution. It determines the general terms of engagement: the universe of applicable rights and, critically, the responsibilities of the fund manager and its investors.

Think of a side letter as a contractual bill of rights that enumerates additional rights—not included in the LPA—for specific investors.

Side letters are also known as “letter agreements” and have much broader applicability in legal world. Which is to say that you can have a side letter for almost any kind of contract.

But in investment management, these documents usually refer to a bundle of terms and conditions certain investors have over and beyond other investors attached to the commitment of capital to an investment fund.

As we dig deeper, we will see that side letters are both powerful but—and this should hardly surprise us at this point in our private funds journey—equally controversial.

You are giving certain investors more (and sometimes better) rights than others.

And when you are in the business of professional money management, those rights can create potentially perverse motivations for both the fund manager and a fund’s largest investors. They can also—and certainly have—draw the ire of regulators.

On the flip side, side letters offer important protections and exemptions from an LPA for select investors that legally may not be able to comply with certain of its provisions (perhaps an investor asks to be excused from investments made in gaming or tobacco-related businesses).

Weaker or Stronger Documents?

There is an academic theory—proposed by William Clayton at BYU Law—that fund negotiations, I’d venture to say through side letters, generate several counterintuitive incentives for larger investors in a fund: these investors prioritize individualized benefits over fund-wide protections that benefit the entire investor base, weakening their incentive to negotiate agreements.

In other words, if such investors are able to secure better terms outside the formal bounds of the LPA (and the LPA’s terms apply to all investors), why spend the additional time or resources negotiating a better LPA? Doing so would mean all investors would enjoy the rights that otherwise would be preserved for a select class of investors. From a bigger investor’s perspective—such as a large endowment or sovereign wealth fund—this makes sense.

You get notice rights that others don’t. You get bespoke economic rights that others don’t. If the fund manager is about to make a controversial investment decision, you get to be the first call (and the majority of other investors may only hear about that decision after the fact).

Here are a few notable rights commonly included in a side letter:

1. Most Favorable Nations (MFN): This is usually the first paragraph of many a side letter. If another investor secures more favorable conditions—lower fees, special reporting rights, or bespoke exit terms—an MFN clause gives eligible investors the option to adopt those same terms. Put differently, when the GP agrees to an MFN clause, it typically commits to notifying the investor if more advantageous terms are granted to another investor. The MFN holder then has the opportunity to elect to receive these better terms, effectively upgrading their own investment conditions. This process often occurs after the fund’s fundraising period ends, through a disclosure and election mechanism. However, MFN clauses are not without limitations. Fund managers often include limits, or “carve-outs,” that qualify when the MFN is triggered. For instance, a carve-out might stipulate that the MFN only activates for investors who have committed capital above a certain threshold. Additionally, some funds provide copies of all side letters to MFN holders, while others may offer a summary of electable provisions.

   Example of a carve-out in real-time: A credit facility is a type of loan arrangement between a lender and a borrower, typically used by private equity funds to access short-term capital. In the context of private equity, these facilities are often secured by the uncalled capital commitments—money pledged but not yet wired—of the fund’s investors. When an investor with MFN rights elects to receive more favorable terms from another investor’s side letter, it can potentially reduce the borrowing base of the credit facility. This is because lenders may need to exclude certain investors from the borrowing base calculation if their side letter provisions are deemed problematic. To mitigate these risks, carve-outs limit the types of provisions an investor can elect from other side letters, helping to protect the fund’s borrowing base and maintain the viability of the credit facility.

   I hope that makes sense? Feel free to shoot me a message if not.

2. Indemnification: Big investors can also use recourse to state law (as public entities) to excuse themselves from the LPA’s indemnification requirements. Indemnification is a contractual obligation where one party agrees to compensate another for certain losses or liabilities. In a side letter there is something usually to the effect of “Under the laws of Honshu Prefecture, Japan, we are unable to provide indemnification to you, the GP. This limitation does not constitute a breach of the LPA.”

3. Sovereign Immunity: Investors can obtain acknowledgement that sovereign immunity under the Constitution’s Eleventh Amendment—specifically for public US investors—is not waived. Sovereign immunity is a legal doctrine that protects states (and related governmental instrumentalities) from being sued without their consent. Among constitutional scholars, this doctrine has faced criticism for lacking clear constitutional grounding and for its inconsistent application.​

4. Litigation/Governing Law: Jurisdiction for legal action/legal proceeding involving any claim arising out of relating to the LPA is brought by the GP against the investor only in certain courts (often the courts native to an investor’s domicile). The investor may also ask the GP to confirm that there are no currently no active litigation matters involving the GP, the manager, or the fund.

5. Political Contributions/Certain Transactions: A few months ago, we talked about political contributions. You’ll get extensive representations from the fund manager regarding its affiliation, activities involving, or donations to causes in connection with geographies, governments, activist movements, etc. that public investors are legislatively prohibited from engaging with or having exposure to (Chinese military companies, for example).

6. Use of Name: The GP agrees that it will not include an investor’s name in any marketing materials of the fund without the investor’s consent.

And these are BIGLY concessions. It is not always easy to get them. The investors that do often have side letters that run well over 60-70 pages. It’s almost like a second LPA.

But remember that side letters are as diverse as the investors in the world of private funds.

Moral restrictions can be brought by, say, a church’s endowment (“The Lord says gaming and gambling are unbecoming of good Christians.”)

Legal restrictions can be brought by a firefighters’ pension (“Statutes prohibit us from investing in Venezuelan oil fields.”).

Moral restrictions that also implicate the law can be brought by a Qatari sovereign wealth fund (“Interest-bearing instruments are morally haram, and as such the Sha’riah legally prohibits us from investing in such instruments.”)

Or sometimes you are raising a $3 million fund, and Uncle Jabberwock is just like “Hey sweetest nephew, I know you said you may invest in biotech, but that’s too risky for me given my frumious Bandersnatch. Can we do a thing where you just partially excuse my vorpal sword. We’d prefer to have exposure to just slithy toves.”

“Yeah Unc, sure. Here you go.”

One and done.

All mimsy were the borogoves.