Great read, thank you for spending the time writing this. Do the majority of these side letter get drafted and signed when the private fund hits first / final close? Or when capital has been called and is being deployed. Presumably it’s entirely dependent on the situation and has to be viewed on a case by case basis.
Interestingly, in the world of hedge funds (open ended vehicles) I have seen legacy side letters cause headaches for the GP but never something that has caused upset to the regulators or other LPs; for example letters with redundant clauses or protections that have been superseded by terms in later rounds of doc updates. Perhaps the lack of external questioning boils down to the nature and vanilla-ness of existing side letters.
Short answer is at the time of closing. It's contractual and is negotiated alongside any changes to the LPA/sub docs/IMA/etc.
HFs are indeed a little different compared to PE/VC, given the continuous outflow/inflow of capital. Likely depends on the particulars of the situation. PPM supplements usually provide the formal updates to any changes made to the governing docs (anything unique to an investor is likely communicated as well if there are conflicts in the existing side letter).
Excellent piece - thank you for your thoughts. Particularly enjoyed the discussion around MFN. I was familiar with this concept in terms of typical credit facilities (i.e., as it relates to the rate lenders receive via the initial facility and whether there's an add-on TL later).
Curious if you can share more thoughts on what specific provisions the fund line lenders might deem as problematic in a side letter, and therefore would exclude that uncalled capital from the borrowing base. Very interesting point. Similarly, other than when a side letter may impact the borrowing base, is the key driver of changes in borrowing base when the GP calls capital (and therefore the remaining amount of uncalled capital is reduced)? Or are there other key factors that impact the fund line borrowing base.
Thanks John, appreciate the kind words and the note. One thing lenders don’t like is the lack of information on investors. Some large investors will ask for a rep in the side letter to the effect of “we will only provide publicly available info for lender due diligence.” That’s a big deal, because the GP will likely have negotiated terms with the lender prior to the admission of some investors (that borrowings language in the LPA is determined through negotiations with the investor).
As for your second question, let me dig around for a resource that might offer a more helpful explanation. If I don’t get back to you in a few days, feel free to ping me!
For larger funds, I’ve heard a significant percentage of their organizational expenses are because of comprehensive side letter negotiations — not just the LPA negotiation. Can you comment on that?
In addition, I understand that many large investors receive reduced fee and carry in their side letters, as well as preferential co-investment rights at a reduced (or zero) fee and carry through their side letters. Generally, this begs the question as to why more of such investors should just invest through a feeder or parallel / customized “fund of one”? Among other things, this would also cause such investors to bear the organizational expenses directly related to their extensive negotiations. What are the pros and cons of this approach?
A brilliant partner once told me that ideally organizational expenses for mega-fund re-raises (so Fund III to IV or IV to V) should be going down. It takes a lot to set up a fund initially, and many of the extensive side letter negotiations with large investors usually carry over (the side letters generally don’t change too much). So the time of negotiations with re-upping investors should decrease. By organizational expenses often go up!
I think you’re right about fund of ones. It’s expensive to set up separate vehicles. I’m not too sure. Some fund of ones involve very large commitments ($250mm+), so the manager might be willing to eat the costs of setting up the vehicle. That might be on incentive for investors to go that route, but it’s a pretty high bar. Other times, the fund of ones might have waived management fees or reduced carry to the manager they wouldn’t have enjoyed in the commingled fund. That’s another potential benefit. There are others as well—did you have any in mind?
A high ticket value for a fund of one can see set up costs waived but it’s unlikely unless the co-investment partner is a genuine long term partner of the GP in other vehicles. GPs by nature do not like to take on unnecessary expenses and in this context it is entirely in line with the market to be charging these extensive set up costs to the LP.
In terms of the management or incentive fee breaks, again that’s possible but usually for long terms partners or giant cheques. If the commingled fund has $2bn AUM and the fund of one is $500m and investing in parallel, there is a material change in AUM so the fee breaks makes sense on both sides. However if the fund of one is a small percentage of the commingled fund then there is not much benefit to the GP in giving fee breaks. Unless it is an LP that has been courted for years and it’s the only way, fee breaks might look a little bit desperate in this context. I also don’t know if you would waive all of the management fees because you would still need to pay for ongoing operating costs etc and if the vehicle is truly investing in parallel, expenses should be allocated accordingly, probably on a pro-rata AUM basis.
Can you add ai reading to your articles please. I'm blind. Thank you
Thanks Ricardo - appreciate you flagging. Didn't know that there was an AI function which could do that on Substack. Let me see what I can whip up.
Great read, thank you for spending the time writing this. Do the majority of these side letter get drafted and signed when the private fund hits first / final close? Or when capital has been called and is being deployed. Presumably it’s entirely dependent on the situation and has to be viewed on a case by case basis.
Interestingly, in the world of hedge funds (open ended vehicles) I have seen legacy side letters cause headaches for the GP but never something that has caused upset to the regulators or other LPs; for example letters with redundant clauses or protections that have been superseded by terms in later rounds of doc updates. Perhaps the lack of external questioning boils down to the nature and vanilla-ness of existing side letters.
Short answer is at the time of closing. It's contractual and is negotiated alongside any changes to the LPA/sub docs/IMA/etc.
HFs are indeed a little different compared to PE/VC, given the continuous outflow/inflow of capital. Likely depends on the particulars of the situation. PPM supplements usually provide the formal updates to any changes made to the governing docs (anything unique to an investor is likely communicated as well if there are conflicts in the existing side letter).
Excellent piece - thank you for your thoughts. Particularly enjoyed the discussion around MFN. I was familiar with this concept in terms of typical credit facilities (i.e., as it relates to the rate lenders receive via the initial facility and whether there's an add-on TL later).
Curious if you can share more thoughts on what specific provisions the fund line lenders might deem as problematic in a side letter, and therefore would exclude that uncalled capital from the borrowing base. Very interesting point. Similarly, other than when a side letter may impact the borrowing base, is the key driver of changes in borrowing base when the GP calls capital (and therefore the remaining amount of uncalled capital is reduced)? Or are there other key factors that impact the fund line borrowing base.
Thanks John, appreciate the kind words and the note. One thing lenders don’t like is the lack of information on investors. Some large investors will ask for a rep in the side letter to the effect of “we will only provide publicly available info for lender due diligence.” That’s a big deal, because the GP will likely have negotiated terms with the lender prior to the admission of some investors (that borrowings language in the LPA is determined through negotiations with the investor).
As for your second question, let me dig around for a resource that might offer a more helpful explanation. If I don’t get back to you in a few days, feel free to ping me!
That’s interesting color - thank you for the follow up! Sounds great on the second question - much appreciated. No rush at all- just curious.
Great post, SK, Esq!
For larger funds, I’ve heard a significant percentage of their organizational expenses are because of comprehensive side letter negotiations — not just the LPA negotiation. Can you comment on that?
In addition, I understand that many large investors receive reduced fee and carry in their side letters, as well as preferential co-investment rights at a reduced (or zero) fee and carry through their side letters. Generally, this begs the question as to why more of such investors should just invest through a feeder or parallel / customized “fund of one”? Among other things, this would also cause such investors to bear the organizational expenses directly related to their extensive negotiations. What are the pros and cons of this approach?
Thanks TS!
A brilliant partner once told me that ideally organizational expenses for mega-fund re-raises (so Fund III to IV or IV to V) should be going down. It takes a lot to set up a fund initially, and many of the extensive side letter negotiations with large investors usually carry over (the side letters generally don’t change too much). So the time of negotiations with re-upping investors should decrease. By organizational expenses often go up!
I think you’re right about fund of ones. It’s expensive to set up separate vehicles. I’m not too sure. Some fund of ones involve very large commitments ($250mm+), so the manager might be willing to eat the costs of setting up the vehicle. That might be on incentive for investors to go that route, but it’s a pretty high bar. Other times, the fund of ones might have waived management fees or reduced carry to the manager they wouldn’t have enjoyed in the commingled fund. That’s another potential benefit. There are others as well—did you have any in mind?
A high ticket value for a fund of one can see set up costs waived but it’s unlikely unless the co-investment partner is a genuine long term partner of the GP in other vehicles. GPs by nature do not like to take on unnecessary expenses and in this context it is entirely in line with the market to be charging these extensive set up costs to the LP.
In terms of the management or incentive fee breaks, again that’s possible but usually for long terms partners or giant cheques. If the commingled fund has $2bn AUM and the fund of one is $500m and investing in parallel, there is a material change in AUM so the fee breaks makes sense on both sides. However if the fund of one is a small percentage of the commingled fund then there is not much benefit to the GP in giving fee breaks. Unless it is an LP that has been courted for years and it’s the only way, fee breaks might look a little bit desperate in this context. I also don’t know if you would waive all of the management fees because you would still need to pay for ongoing operating costs etc and if the vehicle is truly investing in parallel, expenses should be allocated accordingly, probably on a pro-rata AUM basis.
Thanks DM - appreciate you taking the time to add on and clarify here.