Having it their way

As a firm’s fundraising winds down, general partners may be keen to hasten commitments with side letters that accommodate any variety of requests from investors that would be too time-consuming to fold into the partnership agreement. While allowing side letters for certain LPs seems expedient, there can be risks that certain side letters are viewed as preferential treatment by other LPs.
Side letters are a necessity in today’s partnerships, given the diversity of investors, some who are subject to very specific mandates.
However, legal experts advise that side letters should be limited to two issues in the partnership agreement: disclosure and investment restrictions. These two issues will rarely prompt the broader investor base to demand similar arrangements, but once the side letters start addressing other facets of the partnership, they are more likely to appear as favoring certain investors. Most favored nations (MFN) clauses may preempt such concerns, but more often than not, adding a variety of side letter points into the agreement can ensure LPs feel they’re receiving the best service among their fellow investors.
As with many other issues, the largest funds in the market are an exception to this rule, with their sheer volume of investors and institutions requiring a bulk of side arrangements. “If all of the side letter provisions were incorporated into the partnership agreement of a mega fund, the agreement would be several hundred pages long,” says Malcolm Nicholls III, a partner at law firm Proskauer Rose.
For the funds far smaller than those raised by The Blackstone Group or The Carlyle Group, there may be more flexibility to answer such points in the overall agreement. Many fund formation attorneys agree that though the proliferation of side letters should be avoided, certain issues are best settled this way. The two that came up most frequently were disclosure exceptions and investment restrictions.
“Side letters are a terrific solution for exceptions to the restriction on disclosure of information,” says Nicholls. “Public pension funds may need to disclose a certain amount of detail in accordance with applicable law, but those laws don’t generally apply to private pension funds.” The side letter allows for the pension fund to sidestep the broader confidentiality agreement while defining the exact parameters of what they’re able to disclose.
Internal investment restrictions, either by industry and geography, are also a proper issue to solve through a side letter. One attorney noted that for LPs with mandates forbidding investing in gambling and related opportunities, or say, any involvement in the Sudan, the side letter makes an assurance to one investor that’s of no consequence to most other LPs in the fund. “The real question of what should be included in the agreement as opposed to what should be addressed in a side letter is whether the issue is relevant to all investors generally. More robust partnerships reporting requirements or general capital call procedures requested by a specific LP may in fact be desired by other LPs and these types of provisions could easily be added to the agreement,” says Nicholls.
The most inappropriate use of a side letter is one that would materially change the nature of the partnership. One GP found that with investors arriving after the first close, there’s the temptation to revise some fundamental part of the partnership agreement in a side letter, and that frequently what’s “fundamental” isn’t always clear. “Some of the side letters go too far, postinitial closing. So you have to be mindful of LPs renegotiating the agreement through side letters,” says Carl de Brito, a partner at law firm Dechert.
“The MFN clause is one way to alleviate the tension among investors over side letter content,” says de Brito. With these provisions, an investor will be able to review a given point from a side letter and decide to make that point applicable to them, or it can be structured to automatically apply to the investor that signed the MFN provision. Unfortunately, MFN provisions are sometimes limited by the size of the investment, making it difficult in situations with a large investor, where particular parties have a significant share of the economics.
Even with the use of MFN clauses and significant rigor, it may prove too much trouble to argue for fewer side letters. “We try our level best to put as many points in the partnership agreement, but LPs are sophisticated and often insist on their own hot button issues in side letters,” says Marco Masotti, a partner at law firm Paul, Weiss, Rifkind, Wharton & Garrison. Just as too many side letters risk riling up LPs, being stingy on these side agreements can equally grate their nerves. The real question about a side letter whether its allowance or refusal will jeopardize a future commitment.