Back to basics - side letters

United Kingdom

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

 

A side letter is an agreement documenting specific terms relating to a specific investor's commitment to a fund. It is fundamentally different to the fund's main constitutional documents (often based on a limited partnership agreement), which set out the terms that apply to the fund as a whole.

Side letters emerged for the purpose of encouraging cornerstone and strategic investors to commit to a fund by granting them preferential terms in exchange for particularly early or large commitments. However, side letters have become more prevalent in recent years and are now viewed as a fundamental part of the fund-closing negotiation process for most investors.

Who are the parties to the side letter?

Where a fund is structured as a limited partnership, side letters are typically entered into between the general partner (GP) acting on behalf of the fund, and the individual investors.

Some investors will ask for the fund manager entity to be an additional party to the agreement, in order to facilitate the enforcement of any terms relating to the manager's activities. However, both managers and investors should treat this request with caution. Managers should generally look to "ring-fence" liability for side letter obligations within the GP, which is usually a special purpose vehicle. At the same time, recent case law strongly suggests that investors may be forced to shy away from taking legal action against the manager of a limited partnership under a side letter, as this is likely to constitute "taking part in management" of the partnership. A sensible solution is to provide that the GP must procure the actions required of the manager under the side letter, whilst keeping the name of the manager entity itself off the signature block.

Common side-letter terms

The table shows some common side-letter terms.

Common side-letter terms

  • "Most favoured nations"
  • Specific investor reporting requirements
  • Reductions or rebates in the management fee for larger or first close investors
  • Granting the investor a seat on any investor advisory committee
  • Restrictions on the disclosure of the investor's name and its use in marketing materials
  • Additional restrictions or limitations on the fund's investment and borrowing activities
  • Rights for the investor to co-invest alongside the fund
  • Specific tax provisions
  • Participation limits (an investor may seek to cap its investment to a percentage of aggregate commitments in order to control risk exposure)
  • Restrictions on 'distributions in kind' (shares) to investors
  • Notification of certain events to the investor (e.g. change in auditors / departure of key executives)
  • Restrictions on political contributions and use of placement agents
  • Compliance with environmental, social and corporate governance (ESG) policies

We have picked out some of these in more detail below.

Most favoured nations

It is now commonplace for side letters to include a "most favoured nations" (MFN) clause. Broadly speaking, the MFN provision entitles investors to receive a copy of side letters entered into with other investors, and an option to elect the benefit of terms included in those side letters.

In most cases, fund managers are happy to allow MFN rights on a "tiered" basis, meaning that the investor can only elect the benefit of another investor's terms if its commitment to the fund is equal to or greater than such other investor's commitment. In addition, certain provisions may be excluded from the MFN. These include rights specific to an investor's regulatory, legal or tax position or its investment policies, or concessions granted solely on the basis of an investor's status as a "first-close investor" or existing client of the manager.

The MFN process gets more complex where a manager is raising successor funds. Repeat investors often expect substantially similar side-letter rights in respect of a successor platform, leading to a considerable increase in the length and complexity of their side letters with each new fund.

AIFMD

Since the entry into force of the Alternative Investment Fund Managers Directive (AIFMD), AIFMD-authorised managers (AIFMs) are required to disclose details of special arrangements (including side letters) with investors, and the types of investors eligible to receive them. While the AIFMD does not specify the level of detail in which side letter arrangements must be disclosed, AIFMs should certainly bear this in mind.

Reporting provisions

Investors increasingly expect managers to provide tailored reporting beyond what is required under the fund's constitutional documents. This is particularly the case for pension funds, funds of funds and other institutional investors, who are subject to their own strict reporting requirements.

In a fund with numerous investors, compliance with side-letter reporting requirements can become costly and time-consuming for the manager. The manager should therefore consider during the negotiation process whether it has the necessary resources and personnel in place. The costs incurred in complying with additional reporting requirements are sometimes borne by the relevant investor.

US issues

2015 saw large flows of capital into the European real estate market from the US. European managers raising capital from across the pond should therefore be getting used to side-letter requests based on American regulation. For example, side-letter provisions proposed by US public sector investors may be influenced by their need to comply with strict rules prohibiting them from making investments that are:

  • influenced by contributions (financial or otherwise) to an elected official in the investor's jurisdiction;
  • the result of an introduction to the investor via a placement agent; or
  • from which the investor will be required to bear a portion of any placement agent/broker fees.

Summary pros and cons

 

For investors

For fund managers

Advantages of side letters

  • Negotiate tailored terms to address specific needs
  • Ensure parity with other similarly sized investors via the MFN process
  • Offer favourable terms to entice cornerstone investors and larger commitments
  • Save costs by amending a side letter instead of main fund documents (likely to require consent of all investors)

Disadvantages of side letters

  • Confidentiality issues – disclosure to other investors of side letters (albeit redacted)
  • Cost (legal fees and management time) of review and elections during the MFN process
  • Investor relations issues where some investors are granted more favourable terms than others
  • Conflicts of fidicuary duty - manager should not unduly favour one investor over another (which could put the manager at risk of a claim for damages from inestors)
  • Practical difficulties in operating a fund governed by differing terms within a multitude of side letters

Conclusion

Side letters vary greatly in length, from a one-page document to a thesis longer than the fund's constitution itself. Their content also ranges from the mundane, like detailed requirements on the service of notices, to the terrifying, such as clauses restricting investments in entities developing weapons of mass destruction, engaging in organised crime or conducting "indiscriminate mass murder" (some investors obviously feel that the ESG culture has yet to become fully embedded in the market!).

Managers should consider side-letter provisions carefully at all times: during the investor negotiations (with a focus on ensuring that the terms are workable); following closings; during the MFN process; and on a forward basis (to ensure ongoing compliance with their terms).

Please contact the authors if you would like to discuss any of the issues raised in this briefing.