Side letters in the world of private investments: their nature, scope of application and content

For more than a decade, private investments[1] have been a good addition to traditional funds (such as bonds and equities) for institutional investors. However, private investments are typically more contractually complex than their more traditional counterparts.

Some questions of investors may resurface when verifying the documents governing private investments. For example:

• How do we avoid breaching legal restrictions on investing, notably with regard to registered pension plans?
• How can we address ambiguities or gaps in the documentation?
• How can we ensure that we benefit substantially from the same treatment that was given to investors that made a capital commitment of equal or lesser value?

Deadlines for participating in private investments are often tight, and therefore amending constitutive documents to address such questions prior to the closing date is difficult, if not impossible. Furthermore, in practice only major investors can usually influence the content of constitutive documents.

What can be done?

A solution emerged over time to address such issues: negotiating side letters.

Here is an overview of side letters in which we first describe their nature and scope and then provide some examples of typical clauses.

“Side letters” are bilateral agreements between an investor and the private investment manager[2] under which content can be added to the documents governing the fund (such as limited partnership agreements and subscription agreements) and, under certain conditions, amended, to the sole benefit of the investor who is the signatory of such letters.

Usually, following their agreement, side letters become, with respect to the signatory investor, one of the documents governing the private investment. However, to achieve its objective, the side letter must have a paramount nature over the other documents should there be any conflict of their respective terms.

Traditionally, side letters were limited to specific investors, such as initial investors in a fund or investors subject to a specific regulation. Additionally, they were mostly negotiated as part of closed-end funds[3]. However, in recent years, this practice seems to have extended beyond the traditional sphere, in that the use of these letters is now commonplace by all types of investors as well as for investments in open-end funds[4].

Although side letters are usually used for funds that are organized as limited partnerships[5], they are sometimes entered into in funds that take on other forms, such as trusts.

Given their customized nature for each investor, the content of side letters will obviously vary from one investor to the next depending on different factors or circumstances. We will present the most common side letter provisions below.

• Most Favoured Nations (“MFN”)– These provisions typically grant two types of rights to the signatory investor. On one hand, the investor is entitled to receive a copy of side letters negotiated by other investors. On the other hand, the investor may elect to claim the same rights provided in side letters negotiated by other investors who, in principle, made a capital commitment of equal or lesser value to that of the signatory investor in the MFN clause. However, it is important to specify that certain types of rights are often excluded at the outset from the application of MFN clauses, such as those that grant additional information rights (e.g., the sending of additional reports) or that allow the investor—in the case of investments organized as limited partnerships—to designate one of its representatives as a member of the fund advisory board.

• Reduction of management fees – To the extent that a reduction in management fees is granted to the signatory investor, which may be the case especially for early closing investors, this reduction is usually reflected in the side letter.

• Specific regulation – Investors subject to a specific regulation may obtain, among other things, representations from the manager regarding the compliance of this regulation or, alternatively, the right to be released from the obligation to participate in investments that, in the absence of such an exclusion, would result in the investor violating such a regulation. This is the case for registered pension plans or investors that pool such plans (master trust), the funds of which are regulated by the Income Tax Act and pension plan legislation.

• Notification of the occurrence of certain events – The fund manager must notify the signatory investor should an event that could reasonably have a material adverse effect occur, such as the institution of legal proceedings against the fund or the manager’s failure to comply with applicable legislation or the documentation governing the fund.

Furthermore, since most of these fund managers have their own clauses that cover these topics, it is often more efficient and less costly for everybody involved to use the manager in question’s wording, at least as a starting point for negotiations.

As previously mentioned, side letters can be useful for more specific purposes, especially for addressing certain ambiguities identified in the documents governing the fund. For example, such a letter could provide a representation from the manager on how to interpret an ambiguous provision.

In many cases, side letters are an effective and flexible instrument that institutional investors can use for additional protection or to address more specific concerns. While certain clauses are rather standard and widespread in the sphere of private investments, other less common clauses may be justified depending on the circumstances, the nature of the funds, and, above all, the investor’s specific needs.

For more information about side letters, contact Normandin Beaudry’s legal team.

[1] “Private investments” are funds that, in essence, are not traded on a public market, like a stock exchange.

[2] To align this text, the term manager will be used in reference to the entity(ies) that manage the private investment, even though this rule is frequently taken on by a general partner for the funds that are organized into a limited partnership.

[3] Closed-end funds are funds under which investors must generally maintain their interests for a defined term until the termination and liquidation of the funds.

[4] Unlike closed-end funds, open-end funds are funds under which investors can redeem their interests or units in the fund prior to its liquidation, subject to the time frames and restrictions that may be otherwise provided.

[5] For more information about this vehicle type, please consult the following text by the same authors “Beneficial legal considerations of private investments: the game may be worth the candle”.