Side letters: A little extra

The back office burden facing private equity firms is becoming ever heavier under the weight of increased regulation and more detailed and differentiated reporting requirements. Side letter provisions that outline specific terms relating to an LP's commitment to a fund are one way of measuring the growing burden. One Asia-based fund of $1 billion-plus was said to have more than 300 agreements covering just under 100 investors as it moved towards a final close recently.

The problem is not necessarily the volume of side letters as the amount of detail within each document. As one industry participant puts it: "Say you have 40 LPs and 25 are institutional, then you'll get 25 side letters. The number of provisions five years ago would have been 15-20 per letter; now it's 30-40."

The provisions may have no impact on how the fund actually deploys its capital. For example, a European institutional investor could be required by law to secure a commitment that money will not be put to work in weapons manufacturing unless NATO is the end user, even if it is irrelevant to the fund strategy. But the net impact of ever longer shopping lists of provisions, in some cases drafted with little overriding rationale, is protracted fundraising processes as more time is spent trying to reconcile similar but not identical demands.

"Side letters should relate to issues that are specific to certain investors and don't necessarily affect other investors. Unfortunately if a fund has held a first close and investors participate in subsequent closings, then clarifications that would go into the LPA [limited partner agreement] may get swept into the side letters," says Justin Dolling, a partner at Kirkland & Ellis. He recalls one fund with at least 200 provisions over 90 pages of side letter compendium, which was about the same length as the LPA itself.

Negotiating points

Side letters emerged as a means of granting preferential terms, chiefly fee reductions and co-investment rights, to LPs that made early or large commitments to private equity funds. Other common provisions include confidentiality requirements, the award of advisory committee seats, caps on individual contributions as a percentage of the overall fund corpus, and additional restrictions on fund investment and borrowing activity. The areas that have swollen to cover regulatory, tax and reporting regimes.

This has been exacerbated in Asia by larger fund sizes, increasingly institutional LP bases, and incremental movement with each vintage. For many institutional investors, the final negotiating position on the previous fund becomes the starting point for negotiations on the next fund. If a GP was in a weak position last time around - perhaps a Fund I and it was a struggle to get traction with LPs - or it was poorly advised, turning back the tide can be challenging.

"A number of times we have been brought in for a later fund and we see that all their previous lawyers did was take every side letter request in soft copy, put it on GP letterhead and have the GP sign it seemingly without the negotiation," says Andrew Ostrognai, a partner at Debevoise & Plimpton. "It might have made for an easier fundraise, but everyone has a different confidentiality provision, for example, so it becomes a nightmare to administer."

Part of the fund formation lawyer's job is to minimize the impact of multiple requests. In an ideal world, the 15 different confidentiality provisions submitted would be distilled into two or three by trying to find a balance between common ground and room for compromise. Similarly, for non-US LPs concerned that income arising from investments by an offshore fund in the US could be considered effectively connected income (ECI) and taxed locally, a single, uniform blocker would be included in the side letter.

Difficulties emerge when investors insist on specific wording. For example, Germany has in recent years sought to impose tighter controls on how insurance companies access certain asset classes and it was feared at one point that they might effectively be banned from PE. "The uncertainty prompted complicated transfer provisions about what can be done if certain legal changes arise," says Dean Collins, a partner at Dechert. "Different insurance companies might want different wording in their provisions."

Attempts to reconcile investors to particular terms of reference can be time-consuming and are not always successful. Ostrognai recalls one LP that insisted on a statement to the effect that no one had been compensated for raising capital from them. This was clearly untrue, but the GP was able to say that compensation levels for certain individuals were fixed, regardless of whether or not the LP committed to the fund. The LP replied that their senior legal officer insisted on using their version word-for-word.

MFN issues

The kicker is that once these negotiations have been completed the most favored nation (MFN) process begins, and investors are allowed to view side letters entered into with other LPs and elect to receive the same treatment. MFN is usually tiered so that a particular LP cannot demand parity with those who have made larger commitments to the fund. Various terms might also be carved out of the MFN because they are only relevant to certain kinds of investor or because they can't be practically be offered to all, such as special economic rights granted solely for being a first close investor.

"There are ways you can try and manage that process but if it's a large fund there are things that seep through, especially if you don't have the tiered system or you have a lot of investors that are around the same check size," says Dolling.

Factor in the need to manage re-upping investors that might expect similar treatment to the previous fund and believe they have guarantees to this effect, and the situation might become even more challenging. "It can be painful establishing whether an LP can elect a certain provision or not, there might be conflicts," Collins adds. "We keep a running track of the provisions in one document as we go along. If you wait until the end to build from the side letters it can be very time-consuming."

Whether driven by regulatory fiat or institutional investor whim, the goalposts continue to move and it is unclear if and when the industry will arrive at equilibrium. GPs generally try to be accommodating - and the difficult fundraising environment has an impact in this respect - but fulfilling 20 different provisions on disclosure can be frustrating.

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