Imagine you’ve spent months structuring a fund, preparing the offering memorandum, negotiating service provider agreements and finally launching to investors. Everything is in place.
Then a prospective investor comes along and says:
“We like the fund. We like the strategy. We like the team. But…”
Maybe they require additional reporting. Perhaps they need certain regulatory assurances. Maybe they are seeking a different fee arrangement or greater liquidity rights. Whatever the request, it is something that is not already reflected in the fund’s constitutional documents, subscription documents or offering memorandum.
So what happens next?
In the investment funds world, the answer is often a side letter.
Side letters have become a common feature of the investment fund landscape, particularly when dealing with large institutional investors, seed investors, sovereign wealth funds, pension funds and other strategic investors. They provide a practical way for a fund, acting through its directors, general partner or other governing body, to accommodate the specific requirements of particular investors without amending the terms applicable to every investor in the fund.
In this article, we take a closer look at what side letters are, why they are used and some of the key considerations for Cayman Islands investment funds.
What is a Side Letter?
There is no single statutory or universally accepted definition of a side letter. In practice, a side letter is a separate written agreement entered into between a fund and one or more investors that grants rights, protections or arrangements that differ from, supplement or clarify the terms already contained in the fund’s constitutional documents, offering memorandum or subscription documents.
Put simply, a side letter allows a fund to offer an investor a customised arrangement without rewriting the rules for everyone else.
Funds may agree to side letters for a variety of reasons. Often, the investor is making a significant commitment to the fund, investing at an early stage of the fund’s lifecycle or is subject to specific regulatory, tax or internal policy requirements that necessitate additional protections or accommodations.
The rights granted under a side letter can vary considerably depending on the circumstances, but commonly include:
- preferential fee arrangements, including reduced management or performance fees;
- enhanced reporting and information rights;
- special redemption or withdrawal rights;
- regulatory or compliance-related representations and undertakings;
- most-favoured nation (MFN) rights;
- priority rights to participate in future investment opportunities, co-investments or successor funds; and
- other bespoke rights negotiated between the fund and the investor.
While side letters can be an effective fundraising and investor relations tool, they are not without limits. Before granting bespoke rights to an investor, the fund and those responsible for its operation should carefully consider whether the proposed arrangements are consistent with the fund’s constitutional documents, offering memorandum, applicable law and any duties owed to the fund and its investors generally.
After all, while flexibility is often one of the attractions of offshore investment structures, not every investor request should result in a customised deal.
Why Do Funds Use Side Letters?
At first glance, side letters may seem somewhat contradictory.
After all, if investors are investing in the same fund, shouldn’t they all be treated the same?
The short answer is yes, but not necessarily in the way many people think.
The operators of a fund, whether acting as directors, a general partner or through another governing body, are generally expected to act in the best interests of the fund and to treat investors fairly. Fair treatment, however, does not always require identical treatment.
When a fund launches, all investors are typically offered the same investment opportunity through the offering memorandum, constitutional documents and subscription materials. Those documents establish the rules of the game and create the framework within which investors participate.
However, not all investors arrive at the table with the same objectives, regulatory requirements or bargaining power.
Consider, for example, a pension fund that requires additional reporting to satisfy its internal compliance policies. A sovereign wealth fund may require specific regulatory representations before it can invest. A seed investor committing a substantial amount of capital at an early stage may seek economic incentives in recognition of the risks associated with being one of the fund’s first investors.
In each of these cases, the investor may be seeking something different, but not necessarily something unfair.
From the fund’s perspective, accommodating reasonable investor requests can be an effective way to attract capital, establish strategic relationships and broaden its investor base. Side letters provide the flexibility to address these investor-specific requirements without requiring amendments to the terms applicable to every investor in the fund.
Importantly, side letters are usually negotiated rather than offered as a matter of course. Investors who wish to obtain additional rights, protections or accommodations generally need to identify their requirements and negotiate them with the fund. In practice, some investors may have greater leverage than others due to the size of their commitment, their strategic importance or their particular regulatory constraints.
The existence of side letters does not mean that a fund has abandoned the principle of fair treatment. Rather, side letters are often a mechanism through which the fund balances the needs of certain investors against its broader obligations to the fund and its investor base as a whole.
As with most things in the investment funds industry, the challenge lies in finding the right balance between flexibility and fairness.
Common Provisions Found in Side Letters
No two side letters are exactly alike.
Some may consist of only a few paragraphs addressing a specific regulatory requirement, while others can span dozens of pages and cover everything from fee arrangements to detailed reporting obligations. The content of a side letter will ultimately depend on the needs of the investor, the flexibility of the fund’s governing documents and the willingness of the parties to negotiate.
That said, certain provisions appear time and time again.
Fee Arrangements
One of the most common requests involves fees.
An investor committing a significant amount of capital, particularly during the early stages of a fund’s launch, may seek a reduction in management fees, performance fees or other charges. In many cases, these arrangements reflect the investor’s role in helping the fund achieve critical scale or attract additional investors.
Interestingly, the party granting the concession may not always be the fund itself. For example, where management fees are payable to an investment manager, any reduction or waiver will often require the investment manager to be a party to the side letter, as the fund cannot ordinarily agree to waive compensation that belongs to someone else.
Enhanced Reporting and Information Rights
Institutional investors frequently require more information than the average investor.
A side letter may provide for additional reporting, more frequent performance updates, portfolio transparency reports or access to information necessary for the investor’s internal compliance, regulatory or risk management functions.
While these requests are generally straightforward in principle, they often require careful coordination with the fund’s administrator, investment adviser or other service providers responsible for producing and distributing the information.
Special Redemption and Liquidity Rights
Not all investors have the same liquidity requirements.
Some investors may seek shorter notice periods, additional redemption opportunities or the ability to redeem in circumstances where other investors cannot. These provisions are particularly common where an investor is subject to regulatory, governmental or internal policy constraints.
However, liquidity rights must be approached carefully. A redemption right granted to one investor should not adversely affect the rights of other investors or compromise the orderly operation of the fund.
Regulatory and Compliance Provisions
For many institutional investors, the side letter is less about economics and more about compliance.
Pension funds, sovereign wealth funds, insurance companies and other regulated entities often require specific representations, undertakings or confirmations before they can invest. These provisions may address matters such as anti-money laundering procedures, sanctions compliance, tax reporting obligations or regulatory status.
In some cases, the side letter simply bridges the gap between the fund’s standard documentation and the investor’s internal requirements.
Most-Favoured Nation Rights
A side letter may also include a Most-Favoured Nation (“MFN”) provision.
An MFN provision generally allows an investor to benefit from certain rights granted to other investors through subsequent side letters, subject to agreed conditions and limitations. In other words, the investor may not receive every negotiated right immediately, but it gains comfort that it will not be left entirely behind if more favourable arrangements are later granted to others.
Because MFN provisions can become highly technical, we will examine them in greater detail later in this article.
Future Investment Opportunities
Some investors are interested in more than a single investment.
A side letter may provide rights relating to future investment opportunities, including participation in co-investments, successor funds, parallel vehicles or other investment products sponsored by the same group.
These arrangements are often particularly attractive to strategic investors seeking a long-term relationship rather than a one-time allocation.
Bespoke Rights
Of course, not every side letter provision falls neatly into a predefined category.
Some investors may require rights driven by their jurisdiction of residence, tax status, regulatory obligations or internal investment policies. Others may seek accommodations that are unique to their circumstances.
The flexibility to address these investor-specific requirements is one of the primary reasons side letters have become such a common feature of the investment funds industry.
Are There Any Limits?
Absolutely.
Although side letters provide flexibility, they are not a licence to disregard the interests of existing investors or rewrite the economics of a fund in a manner that would be unfair or prejudicial to others.
For example, imagine an investor requests the right to subscribe for shares at a price lower than the net asset value per share applicable to all other investors. While commercially attractive for that investor, such an arrangement would effectively transfer value from existing investors and could raise serious legal, fiduciary and fairness concerns.
Does that mean the fund cannot achieve a similar economic result?
Not necessarily.
Depending on the circumstances, a comparable outcome may be achieved through alternative mechanisms or other structures that are properly disclosed and implemented without diluting the interests of existing investors.
The distinction is an important one. A side letter can often accommodate an investor’s commercial objectives, but it should not do so at the expense of the rights and legitimate expectations of the fund’s other investors.
As a general principle, the operators of a fund should carefully consider whether any proposed side letter provision is consistent with their duties to the fund, the fund’s governing documents and the principle of treating investors fairly.
By now, side letters may sound like a remarkably flexible tool. And they are!
However, flexibility should not be mistaken for unlimited discretion.
Before a fund grants any investor-specific rights, it must first consider whether it has the authority to do so in the first place.
Most Cayman funds that intend to offer side letters expressly reserve the right to do so in their constitutional documents and offering memorandum. These provisions typically provide the operators of the fund with the flexibility to enter into arrangements with particular investors where they consider it appropriate.
This is an important point. A side letter should not be viewed as a mechanism for bypassing the fund’s governing documents. Rather, it is a contractual tool that operates within the framework established by those documents.
Assuming the fund has the authority to enter into side letters, the next question becomes: where are the limits?
The answer will depend on the particular structure, governing documents and circumstances of the fund, but several principles are likely to apply regardless of the structure involved.
First, the operators of the fund must continue to act in the best interests of the fund. The existence of a prospective investment, no matter how significant, does not eliminate this obligation.
Second, all investors should be treated fairly. Fair treatment does not require identical treatment, as discussed above, but it does require careful consideration of whether a particular arrangement could unfairly prejudice other investors or improperly favour one investor at their expense.
Third, a side letter cannot be used to authorise activities that are unlawful, contrary to applicable regulation or otherwise inconsistent with the fund’s governing documents.
Similarly, a side letter should not be used to fundamentally alter the nature of the investment opportunity being offered. The fund’s investment objectives and operational framework exist for the benefit of all investors and should not be undermined through private arrangements with a select few.
Practical considerations also matter. A side letter may look perfectly reasonable on paper, but if the fund, its administrator or other service providers cannot realistically implement the obligations being agreed, the arrangement may create operational difficulties and unnecessary risk.
Ultimately, side letters are not an exception to the rules. They are a product of the rules.
The most effective side letters are those that accommodate legitimate investor requirements while remaining consistent with the fund’s governing documents, the duties of those responsible for its operation and the interests of the investor base as a whole.
Side Letters and Most-Favoured Nation Rights
At this point, it is worth addressing one of the most common misconceptions surrounding side letters.
A side letter and a MFN provision are not the same thing.
A side letter is the agreement itself. An MFN provision is simply one of the many rights that may be included within that agreement.
MFN provisions are common because investors often want comfort that they will not be disadvantaged if another investor later negotiates more favourable terms. In simple terms, an MFN provision creates a mechanism through which an investor may become aware of, and in certain circumstances benefit from, rights granted to other investors through subsequent side letters.
Not all MFN provisions operate in the same way. Some merely require the fund to notify the investor when additional side letters are entered into. Others provide the investor with the right to elect certain rights that have been granted to other investors.
MFN rights are also frequently subject to limitations. For example, they may only apply to investors meeting certain commitment thresholds or may exclude rights that were granted to address a particular investor’s regulatory, tax or operational requirements.
For investors, MFN provisions provide an additional layer of protection and transparency. For funds, they can help strike a balance between accommodating investor-specific requests and maintaining a fair and consistent approach across the investor base.
As with many aspects of side letters, however, the detail matters. Two MFN provisions may appear similar at first glance while operating very differently in practice.
Why Drafting Matters?
Side letters are often negotiated at an exciting stage of the investment process, when the fund is close to securing an investor and everyone is focused on getting the subscription completed.
That is precisely why they need to be drafted carefully.
A side letter is not an informal handshake, a polite side note or a “we’ll figure it out later” document. It is a binding legal agreement that may grant important rights to an investor and impose ongoing obligations on the fund or other parties involved in its operation.
Poorly drafted side letters can create uncertainty, operational difficulties and, in some cases, disputes. For example, a provision may be inconsistent with the fund’s constitutional documents, difficult for the administrator to implement, unclear as to which party is responsible for performing an obligation, or broader than the fund originally intended.
This is particularly important because not every right in a side letter is necessarily for the fund alone to grant. Depending on the arrangement, the relevant parties may include the fund, its directors, general partner, investment manager, investment adviser, administrator or other service providers. A fee waiver, enhanced reporting obligation or regulatory undertaking may require the involvement of different parties, and the drafting should reflect that reality.
Side letters should therefore be approached with precision and care. They should be consistent with the fund’s offering documents and constitutional documents, capable of being implemented in practice, and aligned with the duties owed to the fund and its investors as a whole.
Used properly, side letters can be a valuable tool. They can help funds accommodate legitimate investor requirements, build strategic relationships and raise capital, all while remaining within the framework of the fund’s governing documents.
Used poorly, they can become a source of confusion, inconsistency and unnecessary risk.
As with many things in the investment funds world, the magic is not only in having flexibility, but in knowing how to use it.
If you are thinking about whether or not to offer a side letter to an investor, we would be delighted to help you explore the possibilities. Our team at Vale can walk you through the options, explain how side letters work in practice and help you design an agreement that aligns with your goals.
Please feel free to reach out to:
Shelley Do Vale: shelley.vale@valegroup.ky
Sean Scott: sean.scott@valegroup.ky
Santiago Mtnez-Carvajal: sc@valegroup.ky
