Beware the side letters

LPs' side letter requests can be many - and at times conflicting. When setting up a partnership agreement, GPs should be wary of overcommitting themselves.

Certain LPs have long made special requests that might be attached alongside the main limited partnership agreement in the form of side letters, and as GPs take on more investors, they may be faced with greater numbers of these types of special requests. Managing these side letters – which provide certain LPs with benefits that are generally not available to the other LPs – therefore becomes an important aspect of the investor relations function, and of avoiding lawsuits.

The two key concerns for GPs to keep in mind when it comes to side letters are workability and permissibility. While this may sound obvious, in practice it can be difficult for a GP to discipline itself against promising too much to investors, despite the administrative burden and liabilities that may be created.

?If it becomes difficult to understand your deal because you have so many different business terms scattered all around different documents, that's a practical problem you have to deal with,? says Jonathan Axelrad, a partner with Wilson Sonsini Goodrich & Rosati's fund services and venture capital practice. ?We urge our clients to simplify the collection of documents necessary to understand a deal. You don't want to look at a partnership agreement, miss a side letter, and inadvertently breach a term of the fund.?

When it comes to the permissibility or impermissibility of a side letter request, the main consideration – apart from determining whether the partnership agreement allows for side letters in the first place – is whether the inclusion of the requested provision could be considered injurious to the fund or the other LPs.

Most side letters request fairly innocuous provisions, and many are geared toward facilitating efficiency of reporting and tax treatment for LPs, say GPs and fund formation experts.

However, some requests – which might seem perfectly reasonable when considered individually – can tangle up an unwitting GP in a legal snafu when paired with the requirements stated in the main partnership agreement.

Take, for instance, a case where an investor is legitimately impeded from placing capital outside of certain geographies due to its investment mandate. The LP then requests a side letter which calls for the GP to only invest in companies within a particular state or region. Meanwhile, the GP has been marketing the fund to other LPs as a global fund. ?By issuing the side letter, the GP has now put itself between a rock and a hard place. That's the type of problem that we're always on the lookout for when engaging in side letter negotiations,? says Axelrad. ?Most often, the conflict between the GPs' broad fiduciary duties to the partnership and the side letter is much less extreme; nonetheless, we have to be very careful about conflicting terms.?

A more realistic instance of a potential conflict between the side letter provision and the partnership terms are LP requests for the right to co-invest alongside the partnership. In such instances, the GP needs to confirm that LP co-investments are authorized under the partnership agreement or wouldn't allow a particular LP to ?jump ahead? of the partnership in pursuing an opportunity, says Axelrad. ?You also have to be careful of granting co-investment rights that would, for example, deter strategic co-investors whose participation would be beneficial to the partnership or deal.?

Which party has more leverage when it comes to negotiating side letters is largely determined by the level of interest for a fund. GPs that are in demand have the luxury of being able to turn down side letters without fear of driving away potential investors. One well-established GP told PEM recently that, apart from those provisions that fall under the scope of general administration and communications, it tries to keep the side letters it accepts to a minimum. On the other hand, for those GPs that are struggling to raise first time funds, the temptation to agree to a side letter provision that presents a potential conflict of interest with the partnership agreement and other LPs can be pretty strong.

The bottom line? Says Axelrad, ?If a side letter provision allows other LPs to say, ?We wouldn't have invested if we knew you were going to do this,? then the side letter is probably inappropriate and needs to be considered very carefully.?