Side letters are important legal agreements between private equity fund managers and investors that modify the terms of the primary fund agreements. They allow large or strategic investors to negotiate preferential terms like lower fees, additional information rights, and different investment constraints. There are many common side letter provisions that impact distributions, fees, information sharing, transfers, and more. Understanding side letter terms is critical for both fund managers and investors to properly align incentives and avoid surprises. Key side letter issues include priority profit sharing, distribution waterfalls, confidentiality, in-specie distributions, tax obligations, transfers, conflicts of interest, and use of logos and names.
Priority Profit Sharing Grants Fee Discounts to Large Investors
A priority profit share provision gives certain investors a discounted management fee, often based on the size or timing of their commitment. Early investors or those committing over a minimum threshold like $100 million may receive a 10-20% discount on the annual management fee. This aligns incentives by rewarding anchor investors who provide quick capital and validate the fund’s strategy. However, it can create mismatched economics versus other LPs.
Distribution Waterfall Dictates Timing and Form of Payouts
The distribution waterfall outlines the priority order and timing of capital and profit distributions from the fund back to investors. Key terms include whether payouts follow a deal-by-deal or fund-wide sequence, which investors receive priority, and how different buckets of capital gain preference. Waterfall negotiations often focus on generating faster returns of capital vs maximizing overall profit distributions.
Confidentiality Rules Limit Information Sharing Flexibility
Confidentiality terms govern how much flexibility fund managers have to share investment details and portfolio company information with third parties. This includes data requested by lenders, regulators, auditors, or other investors. Most LPs restrict sharing confidential information but carve out exceptions for critical business needs.
In-Specie Distributions Allow Asset Handoffs
In-specie distribution provisions let the fund make payouts to investors in the form of securities rather than just cash. This provides flexibility to hand over ownership of a portfolio company directly to LPs rather than requiring a sale. It can accelerate distributions but requires coordinated tax planning.
Tax Guidelines Vary by Jurisdiction
Tax guidelines outline the treatment of fund payouts and obligations across different jurisdictions where investors reside. Most private equity funds are structured as pass-through entities so LPs must pay taxes on distributed gains. The side letter spells out required filings, thresholds for withholding, and other tax obligations.
Side letters enable private equity investors to customize key economic and governance terms to fit their preferences. Negotiating advantageous side letter provisions as an anchor investor provides benefits like lower fees, greater information rights, and priority payouts. However, managers must weigh negotiated side letter terms against potential misalignment with other LP interests.