What Is a Side Letter in Private Equity?

Private equity is an asset class where firms raise capital to acquire and manage private companies or take public companies private, aiming for profit upon sale. These investments demand substantial capital commitments over several years. The complex nature of private equity, involving institutional and accredited investors, often necessitates tailored agreements between investors and fund managers. These specialized arrangements address unique investor requirements.

Understanding Side Letters

A side letter in private equity is a confidential, bilateral agreement between a fund manager (General Partner or GP) and an individual investor (Limited Partner or LP). This document supplements or modifies the terms of the fund’s main governing agreement, typically the Limited Partnership Agreement (LPA).

While the LPA applies uniformly to all investors, a side letter carves out specific terms for a particular LP. This allows flexibility in accommodating unique investor needs, stemming from regulatory mandates, tax considerations, or internal policies.

Side letters are common as the investor base for private equity funds has grown to include diverse institutional investors. These agreements provide a mechanism for GPs to grant preferential investment terms outside the standard fund documents. For instance, a large institutional investor like a pension fund might have specific compliance requirements that necessitate bespoke arrangements.

Side letters bridge the gap between a fund’s standardized offering and the individualized demands of certain LPs, enabling broader capital participation. They ensure an investment aligns with an LP’s specific mandates, regulations, or principles without altering the core LPA for all investors.

This flexibility benefits both the fund and the investor, allowing inclusion of capital from investors who might otherwise be unable to participate due to unique constraints. While legally binding, side letters cannot override other limited partners’ interests or vary the LPA’s terms for other LPs without their consent. Funds typically include an “enabling clause” in the LPA that authorizes the GP to enter into such supplementary agreements.

Common Side Letter Provisions

Side letters frequently contain specific clauses addressing investor-specific needs:

Preferential fee arrangements, such as reduced management fees or carried interest for larger investors.
Enhanced reporting requirements, providing more detailed or frequent financial information about the fund’s performance or portfolio holdings.
Co-investment rights, allowing LPs to invest directly alongside the fund in portfolio companies, often without additional fees.
Most Favored Nation (MFN) clauses, enabling an investor to elect more favorable terms negotiated by other investors.
Advisory board seats, giving LPs a direct voice in certain fund decisions and oversight functions.
Investment restrictions or “excuse rights,” allowing investors to opt out of investments conflicting with their mandates (e.g., specific industries or jurisdictions).
Liquidity provisions, such as more favorable withdrawal rights, though more common in open-ended funds.

Negotiating Side Letters

Side letter negotiation is an intricate process usually occurring during a private equity fund’s fundraising cycle. Large institutional investors (pension funds, sovereign wealth funds, endowments) typically request these tailored agreements. Their substantial capital commitments often give them leverage to seek terms differing from the standard Limited Partnership Agreement (LPA).

Discussions often begin before an investor commits to the fund, sometimes even on the eve of closings. Fund managers (GPs) engage in these bilateral negotiations with individual Limited Partners (LPs).

The process balances attracting significant capital and maintaining consistency across the fund’s investor base. Confidentiality is inherent to side letters, as their terms are generally not disclosed to other investors unless an MFN clause is triggered. This confidentiality can sometimes lead to administrative burdens for the GP in tracking bespoke arrangements.

The negotiation process can be time-consuming, adding to the legal and administrative costs of fund formation. GPs must ensure side letter provisions do not contradict the LPA or violate fiduciary duties to other investors. Legal counsel plays a significant role in drafting and reviewing these agreements to ensure enforceability and compliance. The increasing complexity and number of side letters make this negotiation phase challenging for private equity fundraising.

Implications for Private Equity Funds

Side letters carry significant implications for operational dynamics and investor relations within private equity funds. Tailored terms granted to certain investors introduce operational complexities for fund managers, requiring meticulous tracking and compliance with varied obligations.

Managing multiple side letters, each with unique reporting requirements, investment restrictions, or fee arrangements, increases administrative burden and potential for errors. This can divert resources from core investment activities like deal sourcing and portfolio company management.

Side letters can also affect investor relations and perceived fairness among Limited Partners. While confidential, preferential treatment afforded to some LPs can create an uneven playing field, particularly for smaller investors lacking negotiating leverage. This asymmetry in terms (fees, liquidity, information access) can lead to concerns about equity and transparency within the fund.

Regulatory bodies, such as the SEC, have expressed concerns regarding preferential treatment and introduced rules to increase transparency and limit certain terms. Side letters require fund managers to balance accommodating specific investor needs with maintaining fund-wide consistency and fairness. While effective tools for attracting diverse capital and addressing regulatory or tax-driven requirements, their proliferation can complicate fund governance and impact overall fund performance. Careful management of side letters is therefore essential to mitigate legal risks, ensure compliance, and foster trust among all investors in the fund.