In simple terms, a side letter is an agreement which documents terms that are specific to a particular investor's investment in a fund. In that respect, a side letter is distinct from the fund's principal constitutional documents, which set out the terms that apply to the fund as a whole. Side letters have become a fixed feature of most private funds as investors increasingly seek to supplement and improve the terms of their investment and address requirements specific to their position. This briefing explores common themes in relation to side letters and their negotiation, including how side letters interact with a most favoured nation (or “MFN”) mechanism. Common side letter terms Side letters originally emerged principally for the purpose of encouraging cornerstone and strategic investors to commit to a fund by granting preferential terms in exchange for early stage or large commitments. However, investors now see side letters as fundamental to the negotiation process and will often have an extensive shopping-list of requirements. The terms negotiated in a side letter will depend on various factors, such as the type of investor and the investment strategy and legal, tax and regulatory features of the fund. The table below includes examples of some common side-letter terms: We have picked out some of the side letter terms in more detail below. Fee arrangements Managers may grant special management fee and, in some cases, carried interest arrangements with respect to certain investors in order to incentivise repeat, larger and/or early stage commitments to the fund. These fee arrangements may be substantial in the case of cornerstone and strategic investors. While certain aspects of the fee arrangements may sometimes be formalised in the LPA, documenting these arrangements via the side letter provides the manager with greater flexibility to tailor arrangements between different investors in order to preserve fee revenue and avoid creating a precedent. Investment Restrictions Whilst it is not uncommon for closed-ended LPAs to contain an excusal provision - being a mechanism allowing an investor to request to be excused from participation in an investment which would contravene its own legal requirements or investment policies (for example an investment related to armaments manufacture or the production of alcohol) - side letters can offer an opportunity for investors to pre-notify the manager of these prohibitions. The manager will want to limit discretion on the part of the investor so the investor is unable to cherry pick deals. ESG Investors increasingly expect funds to have detailed ESG policies and for managers to commit to firm-level ESG commitments, including net zero carbon emissions targets and alignment with frameworks such as the UN Principles for Responsible Investment. In addition, certain investors may require the manager and the fund to comply with, and/or report in relation to, the investor’s own ESG policies, principles or regimes. Managers should be mindful of ensuring that they are practically able to adhere to and meet any obligations, especially in circumstances where the fund does not exercise control over the underlying investments. Consideration should also be given as to who bears the expense of compliance with ESG related reporting requirements, which may be costly and require input from specialist external providers. Anti-Bribery and Corruption and Sanctions In light of recent events, investors understandably want to ensure that funds into which they are investing are compliant from an anti-bribery and corruption (often referred to as “ABC”) perspective. Related side letter provisions can come in many forms, including assurances that the fund and the manager have implemented ABC and anti-money laundering policies, obligations to comply with the investor’s own ABC policies, and representations and warranties that the fund and the key persons are not the subject of ABC investigations or proceedings. The manager should consider during the negotiation process whether, by agreeing to any such provisions, it is extending its liability beyond the scope of existing ABC regimes applicable to the fund and the manager. Who are the parties to the side letter? Where a fund is structured as a limited partnership, the side letter is typically entered into between the general partner (GP) acting on behalf of the fund, and the relevant individual investor. Some investors will ask for the fund manager entity to be an additional party to the agreement, to facilitate the enforcement of any terms relating to the manager's activities. However, both managers and investors should treat this approach with caution. Managers should generally look to "ring-fence" liability for side letter obligations within the GP, which is usually a limited liability special purpose vehicle. At the same time, case law has suggested that investors in a limited partnership fund may risk prejudicing their limited liability status in taking legal action against the manager of the limited partnership under a side letter, as this could amount to "taking part in management" of the limited partnership. A sensible solution is to provide that the GP must procure the actions required of the manager under the side letter, whilst excluding the manager as a party to the side letter. AIFMD Fund managers whose activities are subject to the EU Alternative Investment Fund Managers Directive (AIFMD), or the equivalent UK regime, are required to disclose details of the nature of special arrangements (including side letters) with investors, and the types of investors eligible to receive them. While the rules do not specify the level of detail in which side letter arrangements must be disclosed, managers should certainly bear this in mind when agreeing to side letter terms with investors. Most Favoured Nations (MFN) An MFN provision is a mechanism, which may be contained either in the fund’s constitution itself (in which case all investors benefit from the MFN on the same terms) or offered to one or more investor(s) within their respective side letters, which typically requires the manager (i) to disclose to relevant investors details of preferential rights granted to other investors in the fund and (ii) to offer investors the right to elect the benefit of certain of those provisions, in each case subject to certain conditions. The election process (and in certain cases the disclosure process too) is typically provided on a “tiered” basis, meaning that the relevant investor can only elect the benefit of (and, as applicable, receive disclosure of) another investor's terms if its commitment to the fund is equal to or higher than such other investor's commitment. In other words, bigger ticket investors generally have a better deal in terms of the rights on offer. Carve-outs In addition to the MFN tiering referred to above, it is common practice for certain types of side letter provisions to be excluded (or “carved-out”) from the MFN. The carve outs may apply solely to the election process, or to both the disclosure and the election process. Carve outs may include, for example, rights granted on the basis of an investor's specific legal, regulatory or tax position or its investment policies, or in consideration of an investor's status as a "first-close investor" or an existing client of the manager. The inclusion of MFN carve outs provides the manager with a means of managing the burden of the MFN process as well as controlling potential escalation in the scope and complexity of side letters across the investor pool, particularly in open-ended products. Some common carve-outs include:LPAC: Investors may be precluded from electing a provision which permits the investor to appoint a representative to the Limited Partners Advisory Committee (“LPAC”). The LPAC is formed for the purpose of consulting with the manager or general partner on specific issues during the lifetime of the fund and the right to appoint a representative to the LPAC may be reserved for larger or first close investors or those investors who the manager otherwise considers to be of strategic importance to the fund. Investor specific legal, regulatory or tax requirements: as described above, certain investors in the fund may be subject to legal, regulatory or tax requirements by reason of their specific individual circumstances. For example, a German domiciled investor may be subject to its own reporting requirements to the German regulator or tax authorities. While the German investor’s side letter may therefore contain provisions entitling it to receive certain information required to fulfil these reporting requirements, a non-German investor would typically be precluded from electing this provision. Co-investments: In certain cases, the manager may agree to grant certain strategic investors first-look rights or pro-rata participation in co-investment opportunities alongside the fund. However, most managers will typically prefer to retain some degree of discretion over the allocation of co-investment opportunities and such side letter rights are therefore often excluded from the scope of the MFN. Summary – Pros and Cons of Side Letters Practical Considerations It is important to remember that side letters are designed to supplement the fund’s constitutional documents and should not be used to replicate provisions of the fund’s constitutional documents. When negotiating side letter rights, managers should always bear in the mind the MFN and, as far as possible, seek to ensure consistency of side letters terms. Consistency in approach between side letters will typically help with streamlining the MFN process and also in facilitating the manager’s ongoing compliance with side letter obligations. In an open-ended fund, investors should only have the benefit to elect side letter provisions granted to other investors admitted at the same or later closings. Further, where closings on open-ended products are anticipated to occur frequently, the manager may even wish to avoid an MFN provision altogether or to restrict the scope of the MFN provisions to fees, redemptions and other essential rights, so as to avoid running a burdensome MFN election process following each closing. Managers should ensure that a record is kept of any key operational side letter obligations, such as deadlines or obligations to notify investors of specific events. An appropriate set of MFN carve outs in the fund’s constitutional documents can reduce the scope of the manager’s ongoing compliance burden. Managers should consider who will bear the costs incurred by the fund and the manager in complying with the specific investor requirements, which investors may seek to push onto the fund or the manager. The MFN process can get complex where a manager is raising successor funds. Repeat investors often expect substantially similar side-letter rights in respect of a successor platform, leading to a considerable increase in the length and complexity of their side letters with each new fund. The inclusion of an MFN provision, in either an investor’s side letter or the fund’s constitutional document, should be carefully considered by both investors and managers alike. Investors should be aware that sponsors will often require MFN elections to be submitted within a certain period following closing. Late MFN election submissions are at risk of being rejected by the manager. Managers may seek to limit their disclosure obligations in the MFN process by choosing to only disclose the general terms or a summary of other investors’ terms, without fully disclosing the specifics. Investors may wish to insist on full disclosure obligations on the part of the manager. Conclusion Side letters can vary considerably in scope and complexity, from a one-page document to an agreement which may be comparable to the fund's principal constitutional document in length. Their content ranges from the mundane, such as detailed requirements on the service of notices, to the ominous, such as clauses restricting investments in businesses involved in the development weapons of mass destruction, or in engaging with organised crime syndicates or persons conducting "indiscriminate mass murder" (some investors obviously feel that the ESG culture has yet to become fully embedded in the market!). Managers should consider side-letter provisions carefully at all times: during the investor negotiations (with a focus on ensuring that the terms are workable); following closings; during the MFN process; and on a forward basis (to ensure ongoing compliance with their terms). Please contact the authors if you would like to discuss any of the issues raised in this article.