With the finish line in sight, GPs nearing a final close on the fundraising trail are becoming increasingly frustrated by intense negotiations around side letter agreements which must be completed first, multiple sources reveal to PE Manager.
Side letters are special agreements – which exist parallel to a fund’s limited partnership agreement (LPA) – made between individual investors and the fund manager. For the most part, side letter arrangements have been used for a variety of reasons, but typically are made at the request of a LP who wants to negotiate an item separate from the partnership agreement. Historically, small requests have been the norm. For instance, a LP may require a particular style of tax reporting. A side letter not stretching past a page could be written to accommodate the request.
But in recent years the size and scope of what investors want to include in their side letters has exploded so that many resemble small books, say legal sources.
When side letters reach this size, GPs are forced to spend more time during the fundraising process negotiating custom terms with individual investors. When that’s done, and the fund is finally closed, a GP then faces the daunting task of tracking all the agreed rights of different investors.
One funds lawyer even went so far as to say that negotiating side letters consumes more time than the creation of the LPA itself.
Part of the reason side letters are growing in length can be attributed to the increasing sophistication of private equity investors. LPs are expanding their internal teams responsible for selecting private fund advisors. As a result of that trend, more LPs are sending out “standard form side letter” requests that make no distinction from one fund to the next, sources say.
And because no attempt is made to fit side letter terms to a particular fund, the end result is more administrative homework for GPs, who must reconcile the request to their particular fund, a second industry lawyer noted.
For GPs, it can be difficult to balance the needs of all their LPs when responding to standard side letter requests.
For instance, a US investor may require a UK fund to provide custom tax reports that fit the rules of US law, and pay the necessary expenses for the GP to provide that. However, the LP may want to add the caveat that if other US investors subscribe to the fund, they will need to pay a proportionate share of the expense. If the GP agrees, and another US investor subscribes to the fund, they may argue against that cost if they didn’t view the custom tax report as necessary. In the end, the GP runs another lap of negotiations around what should be a simple fund term.
To avoid that type of outcome, GPs should carefully draft side letter language so that only investors who elect to opt in to a particular provision – say on reporting or tax filing for example – bears the proportionate cost, advises Geoff Kittredge, a private equity partner at law firm Debevoise & Plimpton.
MOST FAVORED NATIONS
Making matters more complicated (and side letters longer) for GPs is providing investors a most favored nation (MFN) clause. LPs that enjoy a MFN clause have the ability to look at what all the other LPs have negotiated with the GP – subject to any carve-outs – once the fund hits its final close.
“It’s quite typical that investors will cherry-pick other provisions from other side letters they hadn’t originally negotiated,” says Ed Hall, funds partner at law firm King & Wood Mallesons SJ Berwin.
Hall adds that investors often request more terms in their side letters as they observe what other LPs are asking for, which leads other LPs to do the same when learning of the first LP’s requested items.
Legal advisors offer one way out of this self-fulfilling circle of negotiations: GPs can negotiate more carve outs from the MFN clause.
One industry lawyer offers disclosure items as a common example of the types of MFN carve outs that GPs seek. Take large US public pension plans for example. Organizations like the California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS) often negotiate side letter agreements that require a GP to provide fund disclosures that go above and beyond what the partnership agreement mandates. That’s because these public-sector entities must post certain fund financial information to their websites for public consumption. During MFN negotiations, GPs can limit these types of disclosures only to those investors who require them by law.
But GPs must take care of what they carve-out from MFN rights, especially when one side letter agreement could have a significant impact on the position of another investor, warn legal sources. For instance, giving investors the ability to opt out of certain investments, sometimes called excuse rights, will increase the other investors pro rata portion of an investment.
Another example would be if a GP takes a commitment from a state pension plan and agrees to invest 10 percent of the fund in companies in that state. If the GP didn’t disclose that to the other investors, and those particular investments performed poorly, the LPs could claim they didn’t know what they were getting themselves into.
At any rate, side letter negotiations are becoming more convoluted these days. And while traditionally GPs have not perceived side letters as being particularly important during the fundraising process – with most of the big negotiations being reserved for the LPA – the need for greater preparation, and an expectation for more administrative homework as a result of the trend, is becoming more clear with each new investment vehicle launched.