Happy Friday, Funds Family!

Today, we’ll build on last week’s post about negotiations. Specifically, we’re going to focus on side letters.

🤝 When are side letters negotiated?

In many cases, LPs will present the fund with their side letter request very early in the negotiation process. 💌 

Sophisticated LPs often have a “form” side letter they send to every fund. If you’re an LP in a lot of deals, you might consider working with your lawyer to draft a form side letter.

After the LP sends their form side letter, the parties typically negotiate the LPA and the side letter in parallel. In some cases, some of the side letter requests might make their way into the LPA itself, and vice versa. 🔀 

From the LP’s perspective, they want to ensure their desired provisions are somewhere in the LPA or side letter.

As a reminder:

• 📃 If the provision in the LPA, it applies to all LPs

• ✉️ If the provision is in an LP’s side letter, it only applies to the LP with the side letter

🧑‍🏫 GP strategies for side letter administration

If GPs aren’t careful, side letters can get out of control. 🥵 

Three ways to reduce your side letter nightmares include:

1. Decline side letters. Don’t be afraid to “just say no” if an LP asks for a side letter. In many cases (especially where the fund/syndication is in high demand), the investor will capitulate. This is also true if the investor is a small percentage of the total investor base.

2. Avoid MFNs. Don’t give out MFNs like Halloween candy. 🎃 You should aim to give out 0-1 MFNs per fund or syndication. Check out last week’s article for more on MFNs.

3. Copy+Paste. If multiple investors ask for the same provision (for example, an “affiliate transfer” provision), give everyone the exact same language. Once you have a provision you’re happy with, use it as the model for all your side letters. The LPs will understand. We do this on ~every fund we raise for GPs where side letters are in play.

✉️ What do investors put in side letters?

LP side letter requests typically fall into two overall buckets:

• Fund-specific preferential terms. These are provisions like fee discounts or special information rights that put the LP in a preferred position. They may or may not be in the LP’s form side letter request.

• Investor-specific administrative terms. These provisions are in the LP’s form side letter request, and they aren’t very exciting. They’re necessary for the LP to comply with applicable laws, regulations, or tax requirements.

Let’s look at some examples of each.

🏆️ Sample preferential terms in side letters

1️⃣ Most-favored nations (MFN)

MFNs were discussed in detail in last week’s article. This is one of the most powerful side letter provisions out there! 💣️ 

2️⃣ Reduced management fees

The GP may agree to reduce (or waive entirely) the management fees an LP would otherwise pay.

For example, the management fee percentage applicable to the investor could be reduced from 2% annually to 1%.

3️⃣ Reduced carried interest

The GP could reduce (or waive entirely) the carried interest that it would otherwise be entitled with respect to an LP’s investment.

For example, the carried interest percentage applicable to an LP’s investment could be reduced from 20% to 15%.

4️⃣ Co-investment rights

LPs love co-investment rights. ❤️ 

The GP may grant an LP the right to invest their pro rata share (based on fund commitments) in any co-investment or follow-on investment opportunity.

In some cases, an LP might get the right to co-invest with reduced (or waived) management fees and/or carried interest.

5️⃣ Pro rata rights in future funds

Similar to #4 above, an LP might get the right to invest a certain dollar amount (or percentage of total commitments) in the sponsor’s next investment fund.

6️⃣ Limited Partner Advisory Committee

Many investment funds have a limited partner advisory committee (LPAC) that makes decisions on behalf of the LPs.

Side letters often give investors the right to be on the LPAC. ✅ 

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.

🤓 Sample administrative terms in side letters

1️⃣ Excluded investments

Some LPs have a list of investments they absolutely won’t invest in. 🛑 

If the fund invests in any of these categories, the GP will exclude the applicable LP from the investment.

Common excluded investments include:

1. Drugs

2. Alcohol

3. Porn

4. Weapons

5. Cryptocurrency

6. Fossil fuels

7. Non-US investments

In some cases, a government investor (let’s say an Arizona state institution 🌵) might request to be excluded from any investment outside of Arizona.

2️⃣ Affiliate transfers

The general rule in most funds and syndications is that investors cannot transfer their investment in the fund to other parties without the GP’s consent. ⚠️ 

In many cases, LPs will ask for the right to transfer their interest in the fund to their affiliates without needing the GP’s approval.

3️⃣ Confidentiality

Side letters can have all sorts of special confidentiality provisions for LPs. 🤫 

For example, a fund-of-funds investing in a fund or syndication might request the right to disclose certain information to its own underlying investors.

Many LPs also request side letter provisions preventing the GP from publicly disclosing that the LP is an investor in the fund without the LP’s permission.

4️⃣ Tax and regulatory provisions

Many LPs (especially non-US investors, tax-exempt investors, banks, and government investors) have a cornucopia of special tax and regulatory provisions in their form side letter requests.

🛝 Sliding LPA requests into a side letter

In some cases, an LP might ask for a provision to be put in the LPA. 📃 

But perhaps the GP doesn’t want to change the LPA! 🙅 Maybe the fund has had an initial closing already and they don’t want to go through the headache of having the LPs approve an amendment.

The solution is often to put whatever the LP asked for in a side letter.

For example, an LP might ask for a cap on organizational expenses. This is something that would typically go in the LPA.

However, to make the process easier, the parties might agree to put the organizational expense cap in a side letter. ✉️ 

This is a very common practice.

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.