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Understanding “Side Letters” When Raising Capital

Should you find yourself in the position of raising capital for a private fund, you should become familiar with a very common, yet often misunderstood, tool of this particular trade: the side letter. It’s a deceptively simple name for what can be a sophisticated and nuanced way to secure individual investors on their terms.

Private equity funds are most often run as limited partnerships. By doing this, individuals seeking to invest become limited partners and thus allows them to reap the benefits of the management’s work without actually having to do much of the managing themselves. Limited partners by their name are limited in their power and control of the partnership because they are mostly there to bring in capital that is then invested or otherwise spent by the general partner.

Depending upon the investor that the general partner is courting to become a limited partner, the investor can (and oftentimes does) insist upon the execution of a side letter in which the terms of the partnership agreement are altered for that particular investor—and almost always to the benefit of the investor. If the general partner is actively seeking out the investor for regulatory or capital reasons, the investor will have more leverage to demand certain terms in the side letter. At the opposite end of the spectrum, investors who are trying to get a foot in the door will probably not have much, if any, leverage for concessions.

The usual and most common requests made in a side letter on behalf of the investor are to have the fund manager’s fees either partially or completely waived for that investor and to allow the investor to withdraw their money at an earlier date than other investors. Some investors request better access to information about the fund in their side letters. Some go all out and seek Most Favored Nation (MFN) status whereby they are granted the right to get any benefits that are given to other investors in their side letters.

While investors usually have little to lose in obtaining a side letter, and much to gain, the fund managers are in a more delicate position when it comes to issuing these side letters. Many investors will not agree to become limited partners without a side letter, meaning different investors will have different terms. This can create a conflict of interest for the fund manager because they will be responsible for stewarding the entire fund for all investors, but also have to honor their obligations with respect to the various side letters with individual investors.

Some side letter provisions, such as the waiver of the management fee, do not trigger any conflict of interest as it does not require the fund manager to prioritize the interests of the side letter investor over the other limited partners. Others, however, such as allowing an investor to withdraw their capital before other investors, can lead to a charge of breach of fiduciary duty to the other limited partners—especially if there are enough investors leaving early to draw down the capital, leaving little to nothing for those who were locked in longer to recoup.

Side letters can be a great solution for luring and retaining capital contributions. However, they must be considered carefully and always with the advice and counsel of an attorney who is very knowledgeable about them. The legal team at Trembly Law Firm can provide those services and answer any questions about side letters that you may have. Contact us today at (305) 431-5678 so we can help you.

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