Private Fund Side Letters: Common Terms, Themes and Practical Considerations

Introduction

Side letters have become a common way of formalizing negotiated arrangements between a private fund and a particular investor¹. Whilst used more widely in the closed-ended fund context (given that such funds often have limited withdrawal rights and greater structural complexity, and generally involve greater levels of negotiation), they are also a feature of open-ended funds, for instance where there is a seed or cornerstone investor investing significant capital, or an investor subject to specific tax or regulatory regimes which require bespoke terms.

A side letter supplements the terms of the fund's constitutional documents and, where the fund takes contractual form (such as a partnership), can override such terms, and is typically required where an investor has specific commercial, legal, regulatory, taxation or operational concerns with respect to its investment in the fund. In many instances, it is easier to agree concessions in these separate agreements rather than amend the fund's constituting documents (being the constitutional documents such as the partnership agreement or articles, and any accompanying offering memorandum or private placement memorandum), especially as the latter approach would mean the rights agreed would generally then be available to all investors. Some rights are also most practically recorded in a side letter (for example, confirmation of an advisory committee seat for a closed-ended fund)².

This article provides an overview of common side letter terms and current themes in the private fund market. It also considers the regulatory context and practical points for managers navigating the restrictions and obligations of multiple side letters.

Common terms

Most favored nations ("MFN") rights

An MFN right allows an investor to elect to receive the benefit of side letter provisions which have been negotiated by other investors, typically by way of a disclosure and election process which is run following the end of the fundraising period of a fund. They have historically been a key term negotiated in side letters, particularly for more significant investors. Managers within the EEA (or who are otherwise subject to the AIFMD) also need to consider their obligations to treat investors fairly and to disclose any 'preferential treatment' of investors (as described below in the 'Regulatory Context' section). As a result of this (and accompanying expectations from investors), European private fund managers often include a clause in the fund's constituting documentation granting MFN rights to all investors, rather than requiring investors to specifically request MFN rights in their own side letters (which remains a more common approach for U.S. managers).

MFN provisions can be drafted in a number of ways (for example some MFNs only cover economic side letter terms), meaning that what the investor may actually be entitled to elect to receive can vary widely. For example, the drafting may vary in respect of: (i) whether the MFN applies to all side letter provisions or just, for example, to certain provisions such as economic terms; (ii) the MFN may be tiered by commitment size and therefore only apply in respect of those provisions negotiated by other investors with an equal or smaller investment in the fund (typically investments by affiliated investors will be aggregated); (iii) certain provisions only being electable by those investors who meet the same requirements as the investor to whom such provisions were originally granted; and (iv) whether the investor can see all side letter provisions which have been agreed (regardless of whether it is allowed to elect to receive them) or just those provisions which it may elect to receive. Again, managers who are subject to AIFMD should be cognizant of their regulatory obligations in this regard, and a common approach is for all terms to be disclosed to all investors, but any carved-out terms are marked as 'unelectable' as part of the disclosure process.

It is also common to carve out certain terms from the MFN (or make their election by other investors conditional), for example, rights granted to first closing or seed investors, fee discounts or more favorable economics (regarding which see further below), rights to participate in co-investments, rights granted due to an investor's specific legal, regulatory or taxation concerns, and the right to an advisory committee seat.

However, even with careful drafting, an MFN right can significantly extend the fund's (or the manager's) obligations; managers should therefore carefully consider which investors' terms are likely to be captured by the MFN when negotiating these (and other) side letter provisions.

Fee discounts/specific economics terms

It has become increasingly common for managers to offer certain investors economic incentives to participate in the fund, most often involving discounts to management fees and/or, more unusually, preferential terms with respect to carried interest or performance fees. Such terms are typically reserved for four broad categories of investors: (1) first closing or 'early-bird' investors who commit to the fund at launch (to help anchor the fundraising and provide a first wave of capital); (2) 're-upping' investors, being investors in a manager's existing fund who commit to the next vintage of the fund (often at the first closing) to continue supporting the manager; (3) investors writing 'large tickets' who agree to invest at least a particular amount to the fund or across the manager's range of investment products; and (4) strategically important investors, who may also be captured by one or more of the other categories, but are otherwise groups with whom the manager is seeking to build a broad and/or long-term relationship. The discounts offered to such investors can sometimes be included in the fund's constituting documents to ensure transparency for all prospective investors as to who may receive preferential treatment, or otherwise would be included in the relevant investors' side letters (and in this case, such terms are typically not available to be elected by other investors who don't meet such criteria under any MFN).

Transfers

Transfer rights are particularly relevant in the closed-ended fund context where an investor cannot easily redeem from the fund should it wish to (unlike open-ended funds, where redemption rights are a core aspect of the fund's terms). Managers negotiating side letters on behalf of a fund should ensure that a transfer right provides them with sufficient comfort with respect to the identity and nature of the transferee (this is particularly the case where the fund has a credit facility and does not want to jeopardize its borrowing base) and that appropriate customer due diligence information will be provided in connection with any transfer. Providing a blanket consent is therefore not advisable. Transferability is particularly important to certain investors, for example certain German pension funds³ who may need to be able to demonstrate free transferability (or as near to free transferability as the fund can practically offer) for regulatory reasons.

Excuse rights

The constitutional documents of closed-ended funds typically include a mechanism whereby an investor can be excused from participating in particular types of investments (generally due to regulatory or other internal policy constraints). Most commonly, an investor must notify the fund of any such restrictions before it invests, and/or the fund may require the opinion of external legal counsel to confirm that the investor is so restricted. If a fund is willing to negotiate excuse rights, it should try to limit the amount of investor discretion in determining what an excused investment is, as the emphasis should be on using the investor's full commitment to the greatest extent possible, rather than allowing it to cherry pick deals. If the scope of the prohibited investments is stated in the side letter itself, it is generally helpful to state why they are prohibited in order to increase the chance that the provision is outside the scope of provisions which may be elected by other investors via a relevant MFN right. Fund managers should also carefully consider the practical implications of granting such excuse rights; for example, if a particularly large investor (or several large investors) have lengthy excuse rights, consideration should be given as to whether the fund's strategy is likely to trigger such excuse rights in any meaningful way, and as a result, whether the fund is likely to be hampered from pursuing its investment strategy if certain large investors are excused from participating in multiple investments.

Enhanced reporting and information rights

These side letter requests can come in many guises, including requests to vary the frequency, format and content of the standard reporting which the fund provides to its investors. Some investors may have genuine tax-related concerns (for example, the need to be supplied with K-1 schedules in order to prepare their U.S. tax returns) or regulatory reporting issues (such as the need to comply with the Solvency II Directive (2009/138/EC)). To the greatest extent possible, any agreement to provide such additional reporting should be both commercially appropriate and operationally practical for the fund and its manager. For example, a request for portfolio-level information should not result in the investor holding information it could use to its competitive advantage or to the detriment of other investors. This is an area of particular sensitivity in the open-ended fund context where portfolio-level information should generally only be provided when stale, e.g., after further trading of the portfolio so that its then-current composition is not selectively shared. Additionally, certain types of investors, such as development finance institutions or intragovernmental organizations, may have bespoke reporting requirements and templates with which they will require fund managers to comply, often with very little room for deviation or flexibility to reflect the practical or operational implications which such reporting requirements may have. Managers negotiating with such investors should review and consider these requirements particularly carefully.

Other common provisions

Issue and background

• Redemption rights (open-ended)Redemption rights may appear in side letters in various guises, including a waiver, or in the case of seed investors, imposition, of a lock-up period. Other common provisions may relate to redemption charges, gates, compulsory redemption terms, etc.

• Notice of significant or key person redemptions (open-ended)A side letter negotiated for an open-ended fund may include a notice provision in respect of significant or key person redemptions. Such provisions are often linked to enhanced liquidity rights (see 'redemption rights' above).

• Distributions in specieIt is not uncommon to negotiate the circumstances in which a fund may make distributions in specie to its investors in a side letter. Commonly, a side letter provision will specify that the manager will be required to dispose of any securities which the fund is proposing to distribute in specie if the investor so elects, and distribute the net proceeds of sale to such investor instead (particularly in respect of a fund dissolution). The exact terms depend upon the fund's documentation, but increasingly, managers are including this right in the constituting documents (partly in recognition of the fact that investors generally prefer to receive cash rather than securities), meaning that investors just have to notify the manager of their preference via a side letter rather than requesting specific rights.

• Advisory Committee seat (closed-ended)Where a fund operates an advisory committee, the committee members are typically confirmed in a side letter with the relevant investor. Certain information rights in respect of advisory committee meetings may also be set out in the side letter. Occasionally, investors may also request the right to appoint a (non-voting) observer to an advisory committee; any such rights (or similar concepts) would also be captured in a side letter.

• Alternative investment vehicles/parallel funds (closed-ended)Certain investors may for legal or regulatory reasons have specific requirements in relation to the use of alternative investment vehicles and parallel funds. Typical side letter provisions may require the investor's consent prior to transferring its interest to such vehicles, the right to review and agree to the constitutional documentation of such vehicles, or certain additional information rights.

• Use of placement agents (closed-ended)Certain investors may require confirmation by side letter that no placement agent has been used or that the fund will not pay fees to a placement agent (sometimes this is to ensure that any 'pay-to-play' rules have been complied with).

• Representations and warrantiesVarious representations and warranties may be requested in a side letter, depending upon the investor's particular needs (for example, it would not be uncommon to see requests for representations stating that the fund and/or its general partner and/or its manager (i) is not subject to any material pending litigation; (ii) has all applicable registrations and licenses in place; or (iii) is not insolvent). To the extent such representations and warranties are accepted, they should be appropriate and proportionate under the circumstances, and should only be made as at the date of the side letter.

• Opinions of counsel from investorsMany funds' documentation require investors' counsel to provide an opinion in relation to certain matters. Accordingly, some institutional investors ask that this requirement be modified via side letter so that the internal legal counsel of such investor may opine, instead of external legal counsel.

• Use of investor name and other confidentiality issuesAs some investors are sensitive to their name being disclosed, they may ask that their consent is required to specifically name them when the fund is undertaking marketing activities. Conversely, an investor may request that certain confidentiality provisions in a fund's documentation be waived in a side letter in order to satisfy its own contractual disclosure obligations. This is a particularly common request from fund-of-fund investors or investors who otherwise have reporting obligations to beneficiaries.

• Due diligence/visits and meetingsIt is not uncommon for an investor to request a process for inspections of the fund manager (and occasionally, of portfolio companies) by the investor, by way of side letter.

• FOIA requestsCertain investors that are public bodies (in the UK, the U.S. and elsewhere) may be subject to freedom of information laws or regulations. They may therefore request a side letter provision allowing them to disclose certain information about the fund following receipt of a valid freedom of information request.

• TaxationA variety of tax obligations and confirmations may be requested by investors due to their specific circumstances. Provisions might include enhanced reporting rights and confirmations that the fund will be managed so as to avoid certain taxation consequences (such as the need for investors to file taxation returns in certain jurisdictions).

The above is a summary of common side letter requests. Whether it is appropriate to grant such requests should be considered on a case-by-case basis.

Themes

Set out below are some current themes that are relevant to negotiating side letter terms.

Co-investments and other alternative ways of investing

In recent years, interest in co-investment vehicles, separately managed accounts and other alternatives to classic commingled funds has increased significantly. Investors commonly seek an acknowledgement in a side letter that they are interested in co-investment opportunities (or a similar election right), but those investors who have consistently invested with a manager across a number of vintages or products (or investors who are otherwise strategically important to the manager), increasingly look to negotiate more favorable rights. These can include specific "first-look" rights to review and participate in co-investment deals, or a specific agreement with regards to fees payable on any co-investment in which they participate. The overall aim by such investors, especially sophisticated investors with the ability to execute quickly on deals, is to gain additional exposure to a manager's 'trophy assets' by way of co-investment, and to pay a lower fee rate (or stipulate that they should be allowed to participate on a fee-free basis), in order to bring their blended fee rate down across the commingled fund and any accompanying co-investment vehicle.

Use of credit facilities

Credit facilities are a popular tool used by closed-ended funds to satisfy short-term bridging needs and smooth the capital call process, providing additional certainty to investors and managers alike as to when money will be drawn down. However, such facilities pose certain distinct issues with respect to side letters which can be problematic, particularly where the lender's ability to take security is compromised or the borrowing base is otherwise restricted or the investor seeks to restrict information flows regarding/from the investor to third parties. Examples of this include where excuse or transfer rights affect the existing credit assessment on the borrowing base.

To the extent a fund has a credit facility and any of the provisions described above are also covered by an MFN right, these issues can be exacerbated because multiple investors may be able to elect to receive the problematic provisions. Managers may therefore wish to include a carve-out in their standard MFN clause in respect of side letter provisions which affect the fund's credit facility, and otherwise ensure that any prospective side letter provisions are reviewed carefully by fund counsel from a fund finance perspective during the negotiation phase.

Key person issues

Key person terms are common in the closed-ended fund context (where a key person event is likely to trigger the suspension of the investment period or have other consequences) but the terms are almost always set out in the fund's constituting documentation. In the open-ended fund context, they are particularly used to tie in certain key persons financially, including required investment levels and notification rights where a key person submits a significant redemption request (which could potentially be linked to favorable liquidity rights). Provisions regarding no bad acts are also common, especially in seed arrangements or where significant investments are made and are often particularly relevant for new or smaller managers where the conduct of a key person is more likely to impact performance of a fund.

Environmental, Social and Governance ("ESG") concerns

The advent of ESG within the investment management world has had a noticeable impact on the way in which managers and investors alike must consider their investments. Within the EEA in particular, the implementation of the Sustainable Finance Disclosure Regulation (2019/2088; 'SFDR'), together with certain other connected or ancillary legislation, now requires managers to make greater disclosures and reporting to investors in respect of ESG matters if they are pursuing sustainability related strategies or conversely limit any discussion of ESG to risk management when this is not the case. In either case, managers may have to deal with investors who have bespoke ESG-related investment and reporting requirements (e.g. exclusion lists), including a confirmation that the fund will comply with the UN Principles for Responsible Investment when making investments, that investee companies comply with the principles of the United Nations Global Compact, that the fund will provide reporting on the principal adverse impacts of the fund's investments or sustainability-related factors or other guidelines that are more specifically tailored to the investor in question, including restrictions on making investments in companies engaged in certain lines of business. If such a provision is contemplated by a fund, it should ensure it is able to comply with these provisions and, from a practical perspective, to provide any reporting agreed and in respect of funds marketing in the EEA, that they are not implying they are doing more from an ESG perspective than is disclosed in the constituting documents.

Regulatory context

Aside from the commercial and practical considerations relevant to agreeing to a side letter provision, there are certain regulatory issues that managers should also bear in mind.

Managers that are subject to the Alternative Investment Fund Managers Directive (2011/61/EU; or "AIFMD") (whether as a European Economic Area ("EEA") based alternative investment fund manager ("AIFM"), managing an EEA alternative investment fund ("AIF") or through marketing an AIF to investors located in the EEA) must comply with the AIFMD rules on preferential treatment. Under the AIFMD, investors must be provided with a "description of how the AIFM ensures a fair treatment of investors and, whenever an investor obtains preferential treatment or the right to obtain preferential treatment, a description of that preferential treatment, the type of investors who obtain such preferential treatment and, where relevant, their legal or economic links with the AIF or AIFM." This disclosure obligation applies prior to investment and following any material changes to such preferential treatments. The introductory recitals of AIFMD also require that any preferential treatment is disclosed in the AIF's rules or instruments of incorporation - this can be achieved through broad disclosure in the private placement memorandum or partnership agreement (although some managers prefer to include more tailored terms to ensure investors are not provided with too much of a 'shopping list'). The ability to request further information from the manager is also commonly included in the private placement memorandum, with summaries of side letter rights typically made available. The inclusion of an MFN provision in the fund's documentation (together with the accompanying disclosure and election exercise) can help managers to meet their disclosure requirements in this regard.

EEA-based AIFMs are also subject to an additional requirement to ensure the fair treatment of investors. In particular, any preferential treatment accorded to one or more investors must not result in an overall material disadvantage to other investors. EEA managers should bear this requirement in mind when deciding whether to agree to a particular side letter provision.

From a U.S. Securities and Exchange Commission ("SEC") perspective, there is concern about an investor being given preferential treatment in a side letter that may have a negative impact on other investors (this was a particular focus of the now-vacated Private Fund Adviser Rule, although the principle remains the same), such as preferred liquidity and information rights. However, such provisions may be acceptable if sufficiently disclosed to the other investors who are able to take the information into account when making their investment decision. The more acute the conflict or significant the potential impact on other investors, the more detailed and extensive the disclosure should be. The SEC staff on examination has been known to review side letters to test whether they are being adhered to and whether proper disclosure was made. Deficiencies in this area can result in negative written findings at the conclusion of an examination and, in sufficiently serious cases, could result in an enforcement referral.

Practical considerations

Below are some practical considerations that could be relevant when managing a fund with side letters:

• Side letters supplement the terms of a fund's constituting documents, so they should be considered whenever these documents are consulted.
• It is better to be consistent in agreeing side letter terms, for example, having a 'house' provision that is stuck to. This allows continuity of application and makes it easier for managers to comply with their obligations.
• Managers with a number of side letters should consider keeping a centralized record of all side letters agreed for the fund, allowing compliance to be monitored on an ongoing basis. Annual (or more frequently if appropriate) certifications from the teams responsible for compliance with individual provisions can support this process. Additionally, technology has emerged in recent years which can help managers to keep a track of their side letter obligations - managers should consider looking at software to assist with this.
• Managers managing open-ended funds can simplify monitoring and compliance by keeping a clear record of when an investor has redeemed (such that the side letter is no longer relevant).
• Whilst it is tempting to immediately move on to the next project after a closed-ended fund's final closing, it is important to ensure the MFN exercise is handled immediately in order to avoid any technical breaches. The MFN exercise ensures that all investors who are allowed to see/elect to receive other investors' side letter provisions are presented with their options within the agreed timeframe. This is typically achieved through an election form and can take some time to coordinate if a significant number of side letters are involved and/or if a complex set of carve outs apply. The need for consistency between side letter terms (including any MFN rights granted) becomes particularly apparent when conducting this exercise.
• When raising a successor to a fund which has side letters, at the start of the fundraise for the successor vehicle, consider putting together a 'master side letter' for the previous fund to check the consistency of obligations which had previously been agreed to (a version of this may already have been created as part of the MFN exercise for the previous fund). This can assist in developing 'house' positions for the current fundraise (which also helps when negotiating with investors) and generally help make side letter compliance easier from the outset.

Conclusion

Side letters are a significant part of a fundraise. Managers should be alive to the implications of agreeing to side letter provisions, considering each term from a commercial, legal, regulatory and operational perspective. MFN rights should be closely considered at the outset, and due care should be given when negotiating side letters as to the potential commercial implications of having to disclose such provisions to the investor base. The themes identified in this note also demonstrate that the private fund space continues to evolve and that managers also need to adapt in order to ensure that they move with the times, rather than getting caught out by a term that is hastily agreed to without the overall implications receiving proper attention.

This document is not legal advice and should not be relied on as such. Parties to a side letter negotiation should seek advice on the particular transaction in light of their circumstances.

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