September 10, 2021

The Top 10 Terms In Side Letters

General partners (GPs) are dealing with an unexpected side effect of the historic expansion of their firms’ assets under management (AUM): an explosion in the number and complexity of side letters, most favored nations (MFN) processes, and limited partner (LP) requests originating from their increasingly complex fund documentation. 

“The private funds industry is well past the point at which side letters have become ubiquitous,” the Private Equity Law Report said in June 2021. For firms, the report continued, the key to succeeding in an increasingly convoluted environment comes “both at the front end of negotiating side letters and at the back end of managing the obligations contained therein over a fund’s life.”

Below we’ve outlined 10 key side letter provisions, highlighting the operational challenges GPs face in complying with these terms. While these are only a handful of the most important provisions commonly found in side letters, GPs are required to comply with all of the promises they’ve made to their investors across all fund documents. To accomplish this, GPs need a purpose-built software solution that turns their complex fund documents from static words into actionable data. By unlocking the data buried in their fund documentation, GPs can organize large amounts of information across funds, assign accountability throughout their organization, and ultimately deliver on the promises made to their LPs.

10. Capital concentration limits 

Similar to investment restrictions, capital concentration limits are negotiated to limit or control the percent of capital that can be placed in any particular geography, industry, or investment class. While this may be a good diversification practice, concentration limits are often demanded by LPs to ensure GPs adhere to certain investment goals and standards. As these concentration limits continue to evolve, particularly in the face of ESG, GPs must be able to quickly understand the concentration of their current portfolio, quickly assess relevant restrictions, and adjust their investment practices accordingly.

9. Confidentiality

Confidentiality requirements have become increasingly onerous for GPs to manage both with respect to the confidentiality of LP information and ensuring that LPs do not inappropriately disclose information about the fund. 

LPs often seek to negotiate bespoke confidentiality provisions that can prohibit a broad range of activities including sharing a specific LP’s side letter or side letter terms and even using the LPs name in conversations with third parties. Individual confidentiality provisions can create a patchwork of obligations that GPs must constantly manage. Failure to comply with confidentiality obligations, particularly for the most sensitive investors, can have real consequences for investor relations teams and future fundraising. 

On the other hand, GPs typically negotiate for their own set of confidentiality obligations with their LPs. Certain LPs – especially public pensions, funds of funds, and other entities who have beneficiary reporting requirements – will routinely ask for waivers to confidentiality provisions to comply with their own reporting obligations. 

To lessen the administrative burden, GPs need a strong process for tracking the confidentiality provisions they agreed to provide their LPs while managing the consent process with LPs who need waivers on the GP confidentiality protections.

8. Transfer rights

The market for secondary fund interests is booming. AUM for dedicated secondaries funds grew from $12.2 billion in 2010 to a record $77.8 billion in 2020, according to Preqin. The growth in the secondaries market has led to increased scrutiny of the transfer rights provision of LPAs. While sales of LP interests in a fund typically require the consent of the GP, LPs are increasingly looking to take advantage of liquidity opportunities in the secondary market. For GPs, this not only means overseeing the sales process to ensure a smooth transfer, but they must now also manage the obligations owed to the secondary buyer who may or may not have the same rights as the previous owner. This requires GPs to have a flexible system in place that allows them to quickly understand and act on all obligations owed to secondary purchasers of fund interests. 

Download our guide for the full list of the most important side letter terms in asset management alongside an analysis of negotiation trends and their short and long-term impacts on GPs’ operations.