In this second of a three part series, we look more closely at side letters and most favoured nation (MFN) clauses in the private equity space.
Fundraising and the negotiation of the limited partnership agreement (LPA) and, in an increasing majority of cases, side letters, are central to the establishment of a private equity fund. The LPA is the sponsor's starting position but investors carry such influence that the negotiation is increasingly driven by large institutional investors seeking to amend the terms of the investment either by negotiating the LPA or, more commonly, by seeking to enter into a separate side letter agreement with the fund's sponsor. Therefore, side letters play a key role for sponsors in the private equity fund raising process.
Side letter provisions modify the underlying fund documentation (most commonly a LPA) to the extent that they apply to the parties to the side letter.
A common example is a side letter provision reducing the management fee payable by an investor or entitling an investor to a seat on the fund's advisory board. However, the degree of customisation is evolving and the demands of large investors are ever increasing.
MFN provisions enable investors to see the preferential entitlements of other investors and pick and choose which of those terms they want to include in their own side letter as well as find additional provisions to request in future private equity fund investments.
Side letters are becoming increasingly tailored to the needs of the global investor base deploying capital into private equity funds and often contain provisions relating to:
- preferential co-investment opportunities in possible future investments, i.e. provisions permitting a fund’s investor to invest directly in an entity that is also backed by the fund with some form of preference attached, (e.g. the offer of a co-investment to a specific investor in priority to other fund investors, including a co-investment ratchet mechanism based on such investor's commitment to the fund);
management fee discounts,( i.e. a discount on the fee for running/administering the fund);
'opt-outs' or excuse rights for certain specified investments such as pork products or tobacco, (i.e. provisions which permit a fund’s investors to opt-out/be excused from providing the relevant fund with funding for specific types of investment);
consultation or even veto rights in respect to certain amendments to the fund documentation, (e.g. the LPA, investment management agreement etc.); and
- a stake in the management company or in a carry vehicle.
The extent to which investors can negotiate such side letter clauses will often be directly proportionate to the amount of capital deployed and the timing of such investment.
Having looked at both the high level overview (part one of this series) and some slightly greater detailed issues (in this second part), we will consider some practical implications of side letters and MFNs for investors and managers in the final part of this series.
In part three of this series we will consider the practical implications of side letters and MFN clauses for investors and fund managers.