Side Letters: Preferential Terms, Practical Challenges

WHAT IS A SIDE LETTER?

A side letter is a contract between a fund and an individual investor, typically entered into alongside the fund’s constitutional documents (such as an LPA, articles of association or trust deed) and the investor’s subscription agreement. Depending on the structure and the terms of the arrangement, the parties may include the fund’s general partner, directors, trustee or investment manager.

Side letters are commonly used to grant preferential terms to individual investors such as enhanced information or reporting rights, fee discounts, waivers of minimum subscription requirements, excuse rights in respect of particular investments, and most favoured nation (“MFN”) treatment.

Once largely associated with seed and early-close investors, side letters are now routinely sought by institutional investors as a condition of their participation in a fund. Such requests are often driven by investors’ own regulatory obligations, internal policies and reporting requirements. This has increased both the volume and complexity of side letter negotiations.

LEGAL BASIS AND KEY CONSIDERATIONS

As a general principle of contract law, a contract cannot be varied without the consent of all parties to it, unless the contract itself provides otherwise. A side letter is a separate contractual arrangement with an individual investor and does not, by itself, amend the fund’s constitutional documents or alter other investors’ rights.

The fund’s constitutional documents should therefore contain sufficiently broad provisions authorising the relevant parties to enter into side letters and grant preferential treatment. The authority to enter into a side letter should also be consistent with the fund’s other contractual arrangements and applicable governance requirements. The interaction between the side letter and the fund’s constitutional documents and subscription agreement should be carefully considered to ensure that the side letter is effective as intended.

The timing of execution is also important. A fund cannot enter into a side letter before it exists. Where terms have been agreed before the fund’s constitutional documents are finalised, appropriate provision should be made to recognise or ratify those arrangements following establishment. Where a side letter agreement is entered into after an investor has become a limited partner, shareholder or unitholder of the fund, the agreement may lack consideration and need to be executed as a deed for it to be enforceable.

Care must also be taken to ensure that preferential terms are consistent with the fund’s constitutional documents and do not circumvent the provisions or amendment procedures set out in those documents. Any terms that would alter the rights of other investors or the arrangements established under the constitutional documents may require a formal amendment rather than a side letter. The offering document should appropriately disclose the fund’s ability to enter into side letters and the potential for certain investors to receive rights or benefits not available to others. Such disclosure should be considered in light of the applicable Cayman Islands regulatory requirements, including the Cayman Islands Monetary Authority’s (“CIMA”) rules governing offering documents and marketing materials.

The identity of the contracting parties is another important consideration. Cayman Islands courts have applied ordinary principles of privity of contract to side letters, generally treating the registered shareholder or limited partner, rather than the underlying beneficial investor, as the relevant contracting party. Where an investment is held through a nominee, custodian or other intermediary, the drafting should ensure that the intended investor is appropriately covered.

Finally, the person or entity executing a side letter on behalf of the fund must have the requisite authority. That authority may derive from the fund’s constitutional documents, the investment management agreement, relevant board or general partner resolutions, or a combination of these.

COMMONLY NEGOTIATED PROVISIONS

Side letters can address a wide range of investor-specific requirements. The following provisions are among those most commonly encountered.

• Most favoured nation rights. MFN provisions allow eligible investors to elect to receive specified terms granted to other investors. These provisions can create a substantial administrative burden, requiring the fund operator to maintain a comprehensive record of side letter terms, identify eligible investors and manage elections within the applicable time limits.
• Enhanced information and reporting rights. Institutional investors frequently request reporting beyond that provided to investors generally, including additional financial, portfolio or look-through information. Such rights should be assessed carefully, particularly where the information could give certain investors a material informational advantage over others, including in relation to investment decisions or the timing of an exit. Confidentiality obligations and applicable legal or regulatory restrictions should also be considered.
• Excuse and exclusion rights. These provisions permit investors, in specified circumstances, to opt out of particular investments or be excluded from them. They may be required to accommodate regulatory, religious, ethical or reputational constraints. While well established in fund practice, excuse and exclusion rights require careful consideration of their implications for investment allocations, the interests of other investors and the fund’s borrowing arrangements.
• Enhanced liquidity rights. In open-ended funds, investors may seek shorter redemption notice periods, preferential redemption rights or bespoke arrangements relating to gates and suspensions. Such terms require particular scrutiny to ensure consistency with the fund’s constitutional documents and to assess whether they could disadvantage other investors or undermine the fund’s liquidity management arrangements.
• Fee discounts and rebates. Preferential fee arrangements may be implemented through a reduction in the fees charged to an investor, a rebate paid outside the fund or another agreed mechanism. The appropriate structure will depend on the fund’s terms and the intended economic outcome. For example, a fee adjustment reflected in an investor’s net asset value may have different accounting and structural implications from a rebate paid separately, and may require consideration of whether a separate share class is appropriate.

INTERACTION WITH SUBSCRIPTION FINANCING

The growth of the subscription finance market has introduced an additional layer of complexity to side letter negotiations. Subscription facilities are typically secured against a borrowing base derived from investors’ uncalled capital commitments and the associated rights to call and receive those commitments. Lenders therefore scrutinise side letter provisions that may affect capital call obligations, the enforceability of commitments or their ability to enforce security.

Provisions of particular concern include restrictions on borrowing or granting security, excuse and exclusion rights, which may result in commitments being excluded from the borrowing base, and confidentiality restrictions that could impede lender due diligence or enforcement.

Other relevant provisions include limitations on investors’ obligations to third parties, sovereign immunity protections, affiliate transfer rights and MFN provisions. In particular, MFN rights may create additional complications if an investor can elect to receive terms that restrict the fund’s ability to borrow, grant security or enforce capital commitments, unless such terms are appropriately excluded from the MFN regime.

Funds anticipating subscription financing should address lender requirements early and incorporate appropriate financing carve-outs into their standard side letter terms to reduce the need for subsequent renegotiation.

REGULATORY CONTEXT AND BEST PRACTICE

Although side letters are a well-established feature of fund structuring, their use raises important considerations around disclosure, governance and equitable treatment of investors.

To manage the associated risks, fund operators should: address side letters in the fund’s constitutional and offering documents from the outset; assess preferential terms for consistency with existing obligations and other investors’ rights; standardise provisions where practicable to streamline negotiations and the administration of MFN elections; ensure that parties to each side letter are or have appropriate authority from the fund and investor of record; incorporate appropriate lender-related carve-outs where subscription financing is contemplated; and maintain a central record of side letters and the rights granted to facilitate ongoing monitoring and administration.

Early planning and appropriate legal advice can help fund operators accommodate investor-specific requirements while managing legal, operational and financing risks.

This article is for general guidance only and does not constitute legal advice. For specific advice on side letters or Cayman Islands investment fund structuring, please contact any member of our funds team.