Originally, the “customisation” of private equity fund terms via side letter was confined to things like promising the investor a seat on the investors’ committee, enhanced information rights, or pre-approved transfers. Although these are important concessions from an investor’s perspective, they are not fundamental to the operational terms of the fund. However, the degree of customisation negotiated by big investors has recently accelerated and broadened in scope.
Specially negotiated terms can now include such things as:
- Preferred co-investor rights for cornerstone investors or, as an alternative, co-investment scaling – effectively, the more the investor commits, the more co-investment opportunities they will be offered by the manager.
- Discounts or rebates on management fees for bigger commitments.
- ‘Excuse’ rights to opt out of certain pre-specified types of investments, which gives the big investor some latitude to calibrate its exposure to underlying investee companies. It also increases other investors’ exposure to investments that the ‘excused investor’ has opted out of.
- Special consent or veto rights with respect to certain LPA amendments.
- A stake in the management company and/or carry vehicle.
Managers typically use side letters to implement these terms, although it might be more appropriate to describe them as ‘special deal’ letters, as they effectively make big changes to the terms on which an investor invests.
Curtailing investors MFN entitlement
The disparities introduced by side letters can be offset by the “most favoured nations” (MFN) clause, a common provision in fund agreements.
Traditionally, the MFN required the fund manager to disclose all side letters to investors generally and, in most cases, entitled investors to elect to receive the benefit of side letter terms.
But more and more funds are cutting back on investors’ MFN rights, peppering the MFN clause with exceptions and limitations:
- For example, an MFN might state that it does not apply to provisions relating to economics.
- A high proportion of buyout funds now structure MFNs on a hierarchical or ‘tiered’ basis, which restricts an investor’s entitlement to benefit from other investors’ side letters according to the size of its fund commitment. For example, an investor who commits £100 million would only be eligible to receive the benefit of terms from side letters signed by other investors who commit up to £100 million, but not from side letters given to investors who commit more than £100 million.
- Some managers don’t include an MFN at all. Cornerstone investors may then negotiate their own customized MFN in a side letter, outside of the knowledge and reach of other investors.
Curtailing investor disclosure rights
In some instances, the manager’s obligation to disclose side letter terms to other investors is ‘tiered’ in the same way – in effect, denying disclosure of the terms of any side letter to an investor who does not commit at least as much as the investor who signed the side letter in question.
This makes it very difficult for investors to understand how good or bad their terms are versus other investors, and may also make it difficult for them to oversee the GP effectively.
Since the global financial crisis, the side letter process has come under the scrutiny of relevant regulatory bodies. As part of its disclosure mandates, the AIFMD now requires the sponsor to disclose to investors, before their investment in the fund, the extent of the sponsor’s ability to have alternative arrangements with investors, a description of those arrangements and the types of investors eligible to receive them. But even though the equal treatment of investors is one of the directive’s key general principles, the AIFMD has had a limited impact on making fund terms more transparent.
Investors should be aware that, behind the disclosed documents of a fund, special deals may have been made with some of their fellow investors. Even if they are comfortable differential rights as part of the operation of a free market, investors should question managers on it as part of their due diligence, so that any investment decision and valuation of fund interests is made on an informed basis.
Where special economic terms are subject to secrecy, investors may in due course be able to calculate (from the fund’s accounts and financial reporting) the level of mean fees being paid, but they will have no way of assessing their position relative to investors making similar sized commitments, for example, nor the economic deals done with investors in separate accounts or strategic contractual arrangements. As in so much else in life, the bigger the cheque, the better the deal.