The Use of Side Letter Agreements in Private Equity Investments
Side letter agreements have long held a place in the private equity fund investment world as they have regularly been used as a means of interpreting, supplementing and even altering the terms contained in partnership agreements and other governing documents. The historical use of side letter agreements has been somewhat limited to addressing special arrangements with certain investors (e.g. seed or early close investors) and/or unique issues that are specific to only a particular investor or subset of investors (e.g. governmental pension plans); however, due in part to an increase in regulation and the related policies being adopted by many institutional investors, there has been a recent proliferation of not only the number of side letter agreements being entered into, but also the types of provisions that are being included in side letter agreements. As such, private equity investors need to give more careful consideration to the idea of side letter agreements, so that they will be able to ensure they fully understand the terms of their investment and how certain agreements made with other investors can affect those terms.
Perhaps the most important, and certainly the first, item that should be considered by an investor before entering into a side letter agreement is whether such agreements are even permitted under the private equity fund’s governing documents. A fund’s governing documents should not only provide the fund manager with the authority to enter into side letter agreements on behalf of the fund, but also clarify that the terms of any side letter agreement, even if inconsistent with the terms that are contained in the other governing documents, will supersede all other agreements and shall govern with respect to the investor that is party to such side letter agreement. This is typically the case with respect to a traditional private equity fund’s governing documents; however, certain investment vehicles (such as hedge funds) have not historically issued many side letter agreements, so their governing documents do not often contemplate the fund entering into side letter agreements. This is something that needs to be carefully reviewed. Additionally, if a partnership or subscription agreement contains a merger clause that clearly states that such documents represent the entire agreement between the parties and are the only agreements that will govern an investor’s investment, you will need to ensure that the language is expanded or clarified so that any side letter agreements entered into are not unintentionally invalidated by such provisions.
Once it is determined that side letter agreements are actually permitted, an investor must then determine whether side letters are the appropriate means for addressing certain terms. For example, if a provision only applies to a single investor (for example, the governing law or jurisdictional requirements of state or municipal pension plans), that provision is probably best suited for inclusion in a side letter agreement, particularly when there are several similarly situated investors that are all subject to slightly different requirements. Most investors would probably prefer to have the entire set of terms that they are subject to contained in the partnership agreement itself, but let’s face it, partnership agreements are long enough as it is, and the amendment process can often be quite burdensome. Administrative efficiency will often outweigh preferences in those instances. On the other hand, if a provision will affect all investors, it needs to be included in the partnership agreement, especially since that is the agreement that all investors have agreed to become a party to.
Perhaps the point of the most contention, and that investors should be most concerned about when it comes to side letter agreements, is whether an investor will be granted “most favored nation” rights to elect the benefit of any provisions contained in the side letter agreements that are entered into with other investors. Although there may be administrative burdens and practical limitations (every investor cannot have an advisory board seat!), at a minimum, the investors need to be provided with any side letter or similar agreements that are agreed to with other investors. Even if investors are not permitted to elect the benefit of many, if any, of the provisions contained in other investors’ agreements, they still need to be provided with the level of transparency that a partner of a partnership is entitled to. That way they will be able to ensure that all investors are being treated fairly and equitably.
Although entering into a large number of side letter agreements can add to a partnership’s administrative burdens and can create increased organizational costs, they can also serve as an important tool in documenting private equity fund investments. It is also not likely that side letters will be going away any time soon. Therefore, investors need to have a complete understanding of how side letter agreements function and how side letter agreements will affect the terms of each private equity investment they make.
This publication is intended for general information purposes only and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.