Side letters: how UK emerging fund managers can avoid giving away their fund

Even in buoyant fundraising environments, emerging fund managers frequently perceive themselves to be in the weaker negotiating position with potential limited partners (LPs). This mindset can result in managers accepting side letter terms to close LP commitments without full consideration of the consequences on their fundraise and future operation of their fund.

Areas covered by side letter terms are far reaching, with LP requests increasing in scope and complexity over the years. The potential size of an LP's commitment is considered in negotiations, with anchor LPs understandably receiving elevated positions. Many side letter terms can have a potential impact on managers and for the fundraise and beyond. Three common terms that may do so are most favoured nations (MFN), co-investment rights and personalised reporting. 

Most favoured nations.

An MFN clause offers LPs the opportunity to receive enhanced rights provided to others but can unintentionally jeopardise a fundraise. Agree to the wrong MFN terms and managers can end up with a significant LP base with rights removed from the agreed position in the limited partnership agreement (LPA). LP rights under MFN clauses should be limited by reference to size of commitments and a set of exclusions. The effect of MFNs on negotiations with other LPs, including those already closed, should not be underestimated.

Practical tips

• Incorporate the MFN into the LPA itself to avoid LPs with differing MFN rights.
• If dealt with in side letters, managers should ensure they stick with a single MFN provision consistent across LPs. If a manager is forced into accepting diverging MFNs, they should have a process to keep track of all agreed MFN clauses and their terms. 

Co-investment opportunities

Ideally, managers retain discretion, subject to managing conflicts of interest, over which co-investment or follow-on opportunities to offer and on what terms. LP co-investment rights in side letters should always be guided by a "main fund first" principle so that managers can prioritise the fund and give themselves the best chance of meeting its target returns without leakage of capacity into co-investment opportunities. Ideally any side letter terms should be limited to an acknowledgment of interest in seeing co-investment opportunities.  

Practical tip

If LPs negotiate the right to be actively offered opportunities, managers should ensure a list of these LPs is recorded and actively managed during the investment period. Ideally this list should be kept relatively short so that the process of offering out co-investment rights doesn't impede the actual deal process. When co-investment opportunities arise and are offered, discuss deal economics upfront if not already agreed in side letters. 

Personalised reporting

Many LPs have specific requirements for reporting in terms of format, data and frequency. The basis for requests can stem from the regulatory status of LPs, LPs' own investor reporting, as well as their operational systems and policies.

Practical tip

Managers should ensure they can meet these requests including both team resource and operational capacity to capture, process and report on the data required. Early-stage investors should be mindful of the level of information which their portfolio companies may have, and the level of influence they may have as a minority investor in forcing certain reporting onto companies. Managers need to have sufficient time to deploy capital and manage the fund portfolio, not just report to investors.

Robust processes

Due to the broad scope of side letter terms and the number of LP requests managers receive, it is important for managers to run a robust side letter process during their fundraise to ensure that they have considered the implications before accepting the terms.

When agreeing terms, managers should ensure consistency of the scope of individual provisions across the side letters with their LP base. A robust record of all side letters terms enables managers to avoid breaching the potential multitude of terms agreed outside of the LPA during the life of the fund.

Osborne Clarke comment

All too often, we see emerging fund managers ready and willing to accept the majority of LP side letter requests. Before doing so, take a pause from the intensity that comes with the pressure during fundraising to secure LP commitments. If you have legitimate concerns around the requests, LPs will consider them. Highlighting  these concerns will not derail the fundraising process but in fact set the GP-LP relationship up for success. 

As Osborne Clarke has extensive experience in negotiating fundraises, if you would like help navigating a successful fundraise as an emerging (or experienced) fund manager, please contact our experts.