Side letters are tricky things. Occasionally, investment managers will sign side letters with investors in their funds. Usually, side letters are agreements with specific investors that give them advantageous terms relative to other investors in a fund.
There are two categories of side letters from my perspective:
(1) Letters that are good for one investor, and that don’t affect any others.
(2) Letters that are good for one investor, at the determinant of the others.
In basically no case should #2 be okay, and yet we see it happen all the time.
Some examples of side letters that could be good for one investor and put others at harm include:
- Lighter “Defaulting Partner” language: Defaulting Partner language basically outlines what the fund can do to a Limited Partner if she/he fails to fund. Examples include: (a) Charging a late fee on late capital calls, (b) the right to sell an LP’s interest to someone else, or (c) totally wiping out the amount of value in the LP’s capital account. If a GP gives an LP more leniency on this term, it may cause one LP to not fund an investment, creating risk for the other LP’s who were counting on the fund to be a certain size/exposure.
- Transferability Rights: If the LP makes it easier for one LP to transfer her/his stake, without putting “permissions” or strong parameters around it, the LP stake could get transferred to an untrustworthy new investor who may default on future capital calls, or who may disclose private information.
- Liquidity Terms: if one investor is allowed to have a different liquidity term than the other investors, it could create less liquidity to the other investors because the manager would have to hold on to their capital more tightly, making the investment less attractive.
- Stricter Indemnification: One investor may not want to allow the fund to claw back past proceeds to fund indemnification costs. This could force the cost of funding indemnification costs disproportionally on other investors.
In short — LP’s SHOULD ALWAYS DEMAND THE ABILITY TO SEE ANY SIDE LETTERS THE GP HAS ENGAGED IN WITH ANY PARTIES.
In the past — we’ve signed the occasional side letter either because an investor (1) wanted a fee discount for anchoring a fund that was hard to raise (2) the investor wanted to make sure they had MFN for any investor of a similar profile to them (aka getting the same fee discounts we’d give to everyone else) (3) wanted a certain allocation right in future funds for either being flexible on getting crammed down on the first fund, or offering us flexible capital we are able to draw on outside of the predicted capital call schedule.
But all of our side letters are ones we can explain, and don’t cause a detriment to any other investor. And that’s the important part.
It’s one of the parts of diligence processes I think falls down a lot. LP’s… always ask to see side letters. Full stop.