Side Letters (SLs) are bespoke, negotiated agreements between investors and funds that are additional and separate from the subscription agreement, offering document and constitutional documents of the fund. Independent Directors are witnessing SLs becoming increasingly long and complex. So, why the uptick?
Investors now have greater bargaining power in a challenging capital raising market. And while fund managers may not always like SLs, they’re not likely to turn down USD 100 million from a pension fund just because a SL is part of the deal.
For Cayman directors, SLs continue to be one of the most challenging, and sometimes controversial, areas of fund governance. Particular care is needed to ensure they are legally valid and that they don’t offer unfair advantages over other investors in the fund. When dealing with SLs, directors need to carefully consider their fiduciary duties which include acting in the best interest of the fund as a whole rather than the interests of one investor or the investment manager. Because of this, Independent Directors are ideally placed to deal with competing interests.
What’s in a Side Letter?
Today some SLs are upwards of ten pages, packed with various investor demands. Here are some common terms investors are negotiating:
- Management and performance fee discounts, sometimes contingent with a longer lock-up
- Most favoured nation (MFN) clauses
- Agreement by the fund to use its reasonable effort to pay redemptions proceeds in cash rather than in-kind
- Stipulated time frames for delivery of financial information (for example: audited financials and performance estimates)
- Directors’ and officers’ insurance
- Up front agreement to consent to transfers of shares between related investor entities
- Jurisdiction for arbitration/choice of law (particularly for pension funds)
- Preferential access to information
- Variation of lock up terms
- Events that require special notice (for example: change of certain service provider such as administrator or auditor)
- Information to assist with investor tax filings
- Right to appoint to an advisory committee (for closed ended funds)
Unsurprisingly, management and performance fee discounts are the most common terms directors encounter. Another notable trend is the inclusion of MFN clauses whereby the investor would benefit from more favourable terms given to subsequent investors.
Information rights are also important for investors. However, for example, disclosing portfolio level information may give certain investors the advantage of being able to determine exit timing before other investors. Enhanced liquidity rights, such as shorter redemption notice periods and key man redemption provisions, can also present difficulties as they may be deemed to materially prejudice other investors. Such terms have in the past come under regulatory scrutiny by agencies like the SEC in the United States. Some Independent Directors agree that offering the proposed SL terms to all other investors is a practical solution to leveling the playing field and avoiding legal issues.
Given the complexity and the potential regulatory issues, Independent Directors typically liase with a fund’s counsel to review the proposed SLs. A legal review may include:
- That the articles of the fund give the directors power to enter into SLs
- That there is no conflict with the fund’s articles
- That there are no conflicts with Cayman law and existing SLs
- That there is appropriate disclosure in the offering document allowing for SLs
- That the correct parties are signing the letter (note: there have been a number of recent lawsuits in Cayman concerning enforceability of SLs)
- That third party rights issues are considered
- Considerations if a new class of shares is being created/required and related implications
It’s not uncommon for SLs from US investors coming into a Cayman fund to have Delaware or New York law as the governing law of the SL. Thus, the US legal angle should also be considered.
The nitty-gritty: monitoring and formalities
It’s important that a log of SLs is maintained so terms can be tracked and monitored, making sure there is no breach of SL terms or conflicting provisions between investors. Typically, the monitoring of the SL log is carried out by a nominated officer from either the compliance or legal team of the fund manager. Good practice is for the fund manager to give a report on the monitoring of SLs to the directors at board meetings. In order to streamline the monitoring and administration of SLs, some fund managers are standardizing SL terms and offering investors a menu they can select from.
Formalities, like dating the SL, are important. Further, ensuring that the directors of the fund execute the SL on behalf of the fund is critical in terms of enforceability. Despite recent lawsuits in Cayman, attempts to have SLs signed on behalf of the fund by the Fund Manager still occur, rather than as required by the directors.
The Cayman Islands Monetary Authority (CIMA) has just released draft regulations which will result in a number of new data points to be added to the Fund Annual Return (FAR). One of the new proposed data points is the number of side letters a CIMA regulated fund has.
There can be compelling reasons why a large investor would be given better terms: to reflect the investment size and risk taken. The directors of a fund need to always balance the risks and rewards and consider if the involvement of certain investors on preferential terms is nonetheless beneficial to the fund as a whole. Given the increase in the volume and complexity of SLs, fund managers often find that having seasoned and experienced Independent Directors on board can be invaluable to mitigate inherent risks with SLs.