Side letter confusion

In today's slow fundraising climate, GPs are going to have to hustle to meet their fund targets, and in some cases that will mean catering to the unique needs and desires of each of their LPs. But no LP wants to know that someone else in the investor group is getting a better deal, so GPs need to tread carefully when entering into a side letter.

It is rare that a GP will enter into a side letter with one investor, and not grant any other investor the same privilege, says David Winter, a partner in Hogan & Hartson's fund formation practice. Instead, a fund sponsor will enter into side letters with multiple investors, but smaller investors might not get the same benefits as the lead investor.

Another common option is that a GP will build a most-favorednation (MFN) clause into the partnership agreement. An MFN clause stipulates that if the GP enters into any side letters, the GP will show all the other LPs the side letter within 30 days, and all investors will have the ability to take advantage of the terms of the side letter if they choose.

The latter is a far better option than the former, so that no LPs are left feeling like “second-class citizens”, Winter says.

“I would say that the biggest issue where a sponsor tells one investor that the sponsor will enter into a side letter with that investor, and tells all other investors that the sponsor will not enter into a side letter with them, is that many institutional investors can be quite unhappy about being put in that situation,” he says. “A lot of institutional investors request an MFN side letter as a standard part of their investment process. And so if you go the route of excluding everyone but one investor from that right, I think it's going to cause you to hit some bumps in the road as you fundraise.”

And of course there are ways of structuring a side letter so that even if all of your LPs have MFN status, you don't necessarily end up giving them all the same benefits. Smaller investors aren't going to opt to take advantage of a side letter that grants a cut in management fees to anyone who commits more than $1 billion, for instance.

Building an MFN provision into a fund agreement can also help to avert another potential issue: if one LP is granted special benefits and the others are not, the rest of the investor group may start to wonder just how much influence that one LP has over the fund. Many investors are hesitant to put capital into a “captive fund”, for fear that the lead LP may have certain governance rights or in some way have special influence over the investment decisions of the GP.

“The institutional investors with whom I work really do view their investments as investments with the senior members of the management team, and it's important to them that those senior managers have free discretion to execute their business plan,” Winter says. “And if there's a very powerful member of the investor group that might have influence over senior management, my clients become concerned, because that lead investor's interests may not be aligned with their own.”

The best course of action is full disclosure, particularly if any of the side letters granted will impact how the fund operates, e.g. if one LP requests a prohibition on gambling investments. If a GP takes money from a state pension fund, and agrees in a side letter to invest 10 percent of the fund in companies in that state, the GP should definitely disclose that agreement. That way, if those investments perform poorly, the rest of the LPs can't claim they didn't know what they were getting into.

Of course, it's best not to let the whole process become too complex, Winter says.

“One problem with side letters is it can be distracting for the sponsor of a fund to have to spend a lot of time during the fundraising process negotiating numerous side letters,” he says. “And then simply from an administrative perspective, properly tracking all the rights in the side letters can be burdensome as well.”

Once again, an MFN provision cuts down on the clutter.

“What I've found is that if a sponsor includes in the partnership agreement a provision that says all investors receive the benefits of every side letter, then requests for side letters go down substantially,” Winter says. “Investors at the lower commitment levels will rely on investors at the higher level to make the appropriate requests. Of course, this doesn't work for everyone, but I've seen it work with success.”