Side Letter Agreements and Private Equity Funds: Limitations on Undisclosed Preferences

   By Michael Wager and Brandi Schmitz on December 7, 2015 POSTED IN SECURITIES & REGULATORY MATTERS

Side letter agreements are a common component of the relationship between registered investment advisers and their largest investors. Side letter agreements often provide expanded rights and preferences to certain investors; concomitantly, other investors have narrower rights. Regulators in the U.S. and UK have raised concerns about undisclosed side letters. So, what are the limitations on the side letters?

The most common terms and conditions found in side letter agreements include:

·         Liquidity preferences or waiver of lock-up rights.

·         Reductions in, or rebates with respect to, advisory fees.

·         Additional information rights.

·         Board observer rights.

·         Co-investment rights.

·         Most favored nation (“MFN”) provisions.

Though there are no direct rules or regulations regarding side letters, regulators have provided some guidance on the legal standards regarding the disclosure of side letter agreements. Typically, a fund’s offering documents will reserve the right for an investment fund to enter into side letter arrangements with other investors and will caution prospective investors that such arrangements may provide for more preferential terms. That said, the Securities and Exchange Commission, in Congressional testimony and in certain enforcement actions, has questioned such vague disclosure, particularly with respect liquidity preferences and access to additional information. Co-investment rights, MFN clauses and fee reductions pose less of a concern for regulators.

As such, fund advisers should continue to include broad disclosure regarding the potential use of side letter agreements in their offering documents.

In addition, some best practices include:

·         Use of standard language (when possible) for side letters.

·         Incorporation of commonly requested side letter terms into primary fund governance documents.

·         Voluntary disclosure (through supplements to investment memoranda) of side letter terms and conditions that raise questions regarding the conflicts of interest or fiduciary obligations of advisers or general partners of investment funds.

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