In the private equity fund market, investors and sponsors often look to memorialize certain understandings in a “side letter” agreement that is separate and distinct from the main limited partnership agreement (“LPA”) that governs the fund. In many cases, side letters contain investor-specific clarifications or other confirmations that are not seen as material points for the other limited partners in the fund. However, in other cases sponsors or investors will seek to include preferential rights (such as management fee “breaks” or other preferred economics, for example) in a side letter agreement to which not all investors will be privy. In those cases, it’s important for both investors and sponsors to keep in mind the considerations set out below, as a failure to do so can lead to catastrophic results.

In ESG Capital Partners II, LP v. Passport Special Opportunities Master Fund, L.P. C.A. No. 11053-VCL (Del. Ch. Dec. 16, 2015) (the “ESG Capital Partners Case”), the Delaware Court of Chancery issued a forceful reminder concerning these practice points. The Court found that a side letter agreement issued to an investor in a Delaware limited partnership (the “Fund”) was rendered useless by the fact that the side letter was entered into one day prior to the limited partner’s entering into the subscription agreement to acquire interests in the Fund, and the “entire agreement” clause included in the subscription agreement did not reference or otherwise contemplate the existence of any side letter agreement. More importantly, the Court also found that, even assuming that the side letter agreement had not otherwise been nullified, the preferential rights granted under the terms of the side letter agreement purported to confer a “super-limited-partner status” upon the limited partner investor in a way that materially and adversely affected the other limited partners in the Fund. As such, the side letter agreement was unenforceable because it amounted to a unilateral amendment of the Fund’s LPA in clear violation of the amendment provisions of the LPA requiring a majority in interest approval of all limited partners of the Fund in connection with any such amendment.

While the unusual facts of the ESG Capital Partners Case involve a general partner who misappropriated assets from the Fund and then later sought to make preferential and disproportionate distributions to a “favored limited partner” (the “Favored LP”) in reliance on the side letter agreement in question, the Court’s findings have universal application for private equity fund investors, sponsors and their respective advisors when side letter agreements are issued by the general partner on behalf of a fund. An important aspect of the ESG Capital Partners Case was that the Fund’s LPA did not reference or otherwise contemplate that the general partner may enter into side letter agreements with one or more limited partner investors. The Court found that the supplemental rights purportedly granted to the Favored LP in its side letter agreement were unenforceable absent a duly authorized amendment to the Fund’s LPA. 

Key Takeaways

The ESG Capital Partners Case serves as an important reminder that private fund managers, investors and practitioners should always consider the following points to ensure enforceability of side letter agreements:

1. Integration Clauses (also known as “entire agreement” clauses)—make sure that each of the fund’s governing agreements include an integration clause that specifically references the fact that the side letter agreement will be a part of the entire agreement of the parties.

2. Subscription Agreement Provisions—in addition to the integration clause, the subscription agreement should also make clear that each applicable investor has received a copy of its side letter agreement (together with all other fund documentation) and is making its investment in the fund in reliance on the terms of all such agreements.

3. LPA Provisions—make sure that the Fund’s LPA specifically references the existence of side letter agreements, and specifically authorizes the general partner to enter into side letter agreements that supplement or alter the terms of the limited partnership agreement. Limited partner investors need to confirm this point as part of their legal diligence processes instead of assuming that a fund manager has this authority. This language would be in addition to the typical “most favored nations” provision included in each investor’s side letter agreement as further evidence that all investors were made aware that certain supplemental and preferential terms may be granted to some but not all investors in the fund;

4. PPM Provisions—make sure that the fund’s private placement memorandum references the fact that the fund may issue side letter agreements, and that it includes a risk factor highlighting the risk that such side letters may be issued to certain limited partners and not others, and that their terms may supplement or alter the terms otherwise provided in the fund’s LPA.

5. Preferential Rights—make sure that any supplemental rights granted to a limited partner in a side letter agreement do not materially or adversely affect the other limited partners in a way that would require an amendment to the fund’s LPA. When unclear, investors or sponsors should seek out advice of counsel.