Here we’ll discuss investment fund side letters. A side letter is an agreement between an investment fund sponsor and an investor giving the investor special rights or privileges.
Note: This article will refer to “investors” (also known as LPs, limited partners, or investor members) and “sponsors” (also known as GPs, general partners, managing members, or managers). For more on this, check out this article on how investment funds are structured.
What is a Side Letter in an Investment Fund?
An investment fund is governed by its “Fund Agreement,” which is either a limited partnership agreement (if the fund is a limited partnership) or a limited liability company agreement (if the fund is an LLC).
When an investment fund sponsor is raising a fund, potential investors might be interested in the fund but don’t like some of the terms in the Fund Agreement. If the fund sponsor is willing to negotiate with the potential investor, there are two main options:
- Amend the Fund Agreement. Amending the Fund Agreement changes the deal between the sponsor/fund and all investors.
- Enter Into a Side Letter. A side letter is a separate contract between the fund sponsor and an investor. Entering into a side letter with a particular investor changes the deal between the sponsor/fund and one particular investor only.
To summarize: A side letter allows an investment fund to give an investor special terms without giving the deal to every investor.
Typical Side Letter Provisions
Side letters can be as short as one page. On the other hand, some side letters are very complicated and can be 20-30 pages or more. Here are some of the most common provisions we see in investment fund side letters:
1. Reduced Management Fees
The sponsor may agree to reduce (or waive entirely) the management fees that the investor would otherwise have to pay. For example, the management fee percentage applicable to the investor could be reduced from 2% annually to 1%.
2. Reduced Carried Interest
Similarly, the sponsor could reduce (or waive entirely) the carried interest that it would otherwise be entitled to under the Fund Agreement. For example, the sponsor’s carried interest with respect to the investor’s commitment could be reduced from 20% to 15%.
3. Excluded Investments
Some investors have a list of investments they won’t invest in. If the fund makes an investment in any of these categories, the sponsor will exclude the applicable investor from the investment.
Common excluded investments include:
- Drugs
- Alcohol
- Weapons
- Fossil Fuels
- Pornography
- Non-US Investments
- Cryptocurrency
4. Right to Transfer to Affiliates
The general rule in most closed-end Fund Agreements is that investors cannot transfer their investment in the fund to other parties without the sponsor’s consent. However, side letters often permit investors to transfer their interest in the fund to their affiliates.
5. Co-Investment Rights
Investors love co-investment rights. The sponsor may agree to give an investor an allocation of any co-investment opportunities. In some cases, an investor might get the right to co-invest with reduced (or waived) management fees and/or carried interest.
6. Advisory Committee Representation
Many investment funds have an advisory committee (or “LPAC” – limited partner advisory committee) that makes decisions on behalf of investors. Side letters often give investors the right to be on the advisory committee. Slightly less important investors might get the right to have a non-voting observer on the LPAC, which enables them to get more information even if they can’t vote.
7. Confidentiality
Side letters can have all sorts of special confidentiality provisions. For example, a fund-of-funds investing in an investment fund might require the right to disclose certain information to its own investors. Many investors also request side letter provisions preventing the sponsor from publicly disclosing that the investor is an investor in the fund without the investor’s permission (except as required by law).
8. Right to Invest in Future Funds
Investors often want to establish long-term relationships with fund sponsors. In some side letters, an investor gets the right to invest a certain dollar amount (or percentage of total commitments) in the sponsor’s next investment fund.
9. Special Regulatory/Tax Provisions
Many investors have specific regulatory provisions in all of their side letters. Some examples of issues that might come up include:
- Regulatory: Banks requiring provisions related to the Bank Holding Company Act (BHCA)
- Regulatory: State-sponsored investors requiring provisions related to government disclosure
- Tax: Tax-exempt investors wanting to limit Unrelated Business Taxable Income (UBTI)
- Tax: Non-US investors wanting to limit Effectively Connected Income (ECI)
10. Most Favored Nations (MFN)
A “Most Favored Nations” provision – also called an “MFN” – is something investors will often request in side letters.
An MFN provision entitles the investor to peek at side letters between the fund and other investors. Typically, an MFN applies to side letters with each investor investing less than (or the same amount as) the investor with the MFN.
So, if an investor with an MFN commits to invest $5 million, that investor will get to review all (redacted) side letters with investors investing $5 million or less.
After reviewing the other side letters, the investor with the MFN can select provisions in those other side letters and incorporate them into its own side letter with the fund (subject to a few exceptions, which are specifically mentioned in the MFN provision).
Investment fund sponsors should always consult with counsel and be very careful when giving out MFNs. Otherwise, fund sponsors may grant a side letter provision to one investor and unintentionally allow many other investors to elect the same benefit.
When Do Fund Investors Sign Side Letters?
An investor and the fund sponsor will sign the side letter on the date the fund sponsor countersigns the investor’s subscription documents and admits the investor as a limited partner (or member) of the fund.
For more information about the timeline and process of forming an investment fund, check out our investment fund formation timeline.
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