Side letters have long been used by fund managers to allow an investor to invest on terms that vary from the main fund agreement. But they are becoming more expansive and secretive, leading to more customized terms for big investors and reduced transparency.
Originally, the “customisation” of private equity fund terms via side letter was confined to things like promising the investor a seat on the investors’ committee, enhanced information rights, or pre-approved transfers. Although these are important concessions from an investor’s perspective, they are not fundamental to the operational terms of the fund. However, the degree of customisation negotiated by big investors has recently accelerated and broadened in scope.
Specially negotiated terms can now include such things as:
Managers typically use side letters to implement these terms, although it might be more appropriate to describe them as ‘special deal’ letters, as they effectively make big changes to the terms on which an investor invests.
The disparities introduced by side letters can be offset by the “most favoured nations” (MFN) clause, a common provision in fund agreements.
Traditionally, the MFN required the fund manager to disclose all side letters to investors generally and, in most cases, entitled investors to elect to receive the benefit of side letter terms.
But more and more funds are cutting back on investors’ MFN rights, peppering the MFN clause with exceptions and limitations:
In some instances, the manager’s obligation to disclose side letter terms to other investors is ‘tiered’ in the same way – in effect, denying disclosure of the terms of any side letter to an investor who does not commit at least as much as the investor who signed the side letter in question.
This makes it very difficult for investors to understand how good or bad their terms are versus other investors, and may also make it difficult for them to oversee the GP effectively.
Since the global financial crisis, the side letter process has come under the scrutiny of relevant regulatory bodies. As part of its disclosure mandates, the AIFMD now requires the sponsor to disclose to investors, before their investment in the fund, the extent of the sponsor’s ability to have alternative arrangements with investors, a description of those arrangements and the types of investors eligible to receive them. But even though the equal treatment of investors is one of the directive’s key general principles, the AIFMD has had a limited impact on making fund terms more transparent.
The ubiquity of side letters, in tandem with the narrowing or outright elimination of MFN rights, means that it is becoming harder to find out, evaluate and obtain for oneself the terms received by other investors in a fund.
Investors should be aware that, behind the disclosed documents of a fund, special deals may have been made with some of their fellow investors. Even if they are comfortable differential rights as part of the operation of a free market, investors should question managers on it as part of their due diligence, so that any investment decision and valuation of fund interests is made on an informed basis.
Where special economic terms are subject to secrecy, investors may in due course be able to calculate (from the fund’s accounts and financial reporting) the level of mean fees being paid, but they will have no way of assessing their position relative to investors making similar sized commitments, for example, nor the economic deals done with investors in separate accounts or strategic contractual arrangements. As in so much else in life, the bigger the cheque, the better the deal.
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