The Down Side of Side Letters in Private Equity

The use of side letters in Canadian private equity and venture capital funds continues to be a common practice, and can assist Funds to secure key investments. However, it is important to understand their legal implications and the limitations on entering into such side letters.

Use of Side Letters

Canadian private equity and venture capital funds are often structured as limited partnerships which are governed by limited partnership agreements (LPA). LPAs are multilateral agreements among the General Partner, the Fund and the limited partners. Certain investors will require side letters, providing them with additional or preferential rights to those granted under the LPA, as a condition to investing in a Fund. In effect, the side letters alter or add to the terms of the LPA for the benefit of a single investor.

The topics covered in side letters will vary, but can include:

  • Fee waivers or adjustments
  • Most favored nation clauses (MFN)
  • Membership in the limited partnership advisory committee
  • Co-investment rights
  • Enhanced reporting rights
  • Enhanced rights to transfer units of the Fund
  • Excuse provisions relating to regulations applicable to an investor, which prohibit certain investments
  • Additional representations and warranties respecting tax, AML and anti-corruption matters
  • Additional limitations on the use of powers of attorney granted under the LPA

Legal Context for the Use of Side Letters

The legal context for the use of side letters in Canada is currently unclear, as there are no Canadian court decisions which consider their effectiveness. However, there are legal principles which will inform a consideration of whether side letter provisions are permissible or enforceable.

The General Partner of a Fund is generally considered a fiduciary to the Fund and has a fiduciary duty to treat all limited partners fairly. Including provisions in a side letter which are more favourable to one limited partner, as compared to another, will raise questions as to whether the General Partner is acting within its fiduciary duty of treating limited partners fairly. One method for mitigating this risk is ensuring that the LPA discloses that the Fund and General Partner may enter into side letters and describing the types of provisions which can be included in such side letters.

As mentioned, the LPA is a multilateral agreement between the General Partner, the Fund and the limited partners. Certain side letter provisions will not affect other limited partners are unlikely to draw legal scrutiny. For example, enhanced reporting rights or additional representations and warranties on matters unique to the regulatory regimes specific to an investor, will not likely attract any challenge from other limited partners.

Other side letter provisions may involve the General Partner agreeing to exercise a discretion it has under the LPA in a specified manner. For example, agreeing to broader transfer rights by a particular limited partner. Once again, such exercise of discretion would not typically affect other limited partners and would not likely attract attention.

However, side letter provisions that amend a provision of the LPA that is fundamental to the Fund and cannot be amended in a bilateral agreement between the Fund and a single limited partner, are more likely to attract legal challenge. For example, if a real estate investment fund with a strategy to invest in Western Canadian real estate, enters into a side letter which further limits its investments to Alberta real estate, would be at higher risk of a successful court challenge. Obviously, such a side letter provision would impact a fundamental aspect of the Fund itself and its investment strategy, which may have been integral to another limited partner’s investment decision.

Ultimately, the assessment of side letter provisions having regard to the multilateral character of LPAs and the fiduciary obligations of the General Partner, will be fact specific, and will require careful consideration by counsel.

US Court Decision Considers Effectiveness of Side Letters

There is one US decision which considered the effectiveness of a side letter in a private equity context: ESG Capital Partners II LP. V. Passport Special Opportunities Master Fund LP (the ESG Decision). In that case, one investor received preferential investment terms through a side letter (that was signed before the preferred investor’s subscription agreement) which were challenged by other investors. Among other things, the side letter provided that the preferred investor had a fixed percentage interest in the fund.

In the ESG Decision, the court concluded that the integration clause in the subsequent subscription agreement (which provided that the subscription agreement constituted the entire agreement between the fund and the preferred investor) had the effect of superseding the side letter, rendering it ineffective.

The court in the ESG Decision found that even if the side letter had not been rendered ineffective for the noted technical reason, it would have been invalid for the lack of the general partner’s authority to grant such rights. Specifically, the general partner could not grant a fixed percentage interest in the fund and override the provisions in the LPA which provided distributions were proportionate to a limited partner’s percentage interest in the fund (which percentage interest was defined as the number of units each partner held divided by the total number of units outstanding). The court noted such provisions were mandatory and could not be altered in a side letter, absent a partner vote to amend the terms of the LPA.

Managing Side Letters

With many investors proposing lengthy side letters, the time and cost of negotiating them can be significant for a Fund. As noted above, the proposed requests will often raise questions as to whether the General Partner can even grant such additional rights and still meet its fiduciary obligations while avoiding negatively affecting the rights of other limited partners.

MFN clauses present their own challenges because they typically require the Fund to provide copies of all other side letters to the investor with the MFN right, and grant the ability for such investor to further amend their side letters to add such additional rights.

Many investors have legitimate reasons for requiring side letters, which Funds will want to accommodate to attract the investment. However, in some cases it appears that investors ask for side letters without consideration of whether the requested provisions are needed, appropriate in the circumstances or commensurate with the investor’s level of investment in the Fund.

Various strategies for limiting unnecessary side letter provisions can include:

  • Resisting side letter provisions which are largely duplicative of existing LPA provisions
  • Anticipating more general requests, which can be built into the LPA for the benefit of all limited partners (for example, defining co-investment rights and limiting the use of powers of attorney)
  • Limiting side letters to regulatory matters which are required for the investor to be able to invest in the Fund
  • Limiting MFN clauses to only the most significant investors in terms of dollars committed
  • Creating a standard set of side letter provisions the Fund is willing to accept and asking investors to choose from such standardized provisions to the extent particular rights are needed

The use of the foregoing strategies will ultimately depend on the negotiating strength of the Fund.

Structuring Fund Documents

To address the technical issue identified in the ESG Decision, it is also important to ensure that the Fund documents are structured to permit the Fund to enter into side letters. This includes:

  • Ensuring the “entire agreement” clauses in the subscription agreement and LPA contemplate potential use of side letters
  • Ensuring the LPA gives the General Partner authority to enter into side letters, which may grant additional or preferential rights to certain investors

The MLT Aikins Private Equity and Venture Capital practice group has extensive experience advising investors on accessing world-class opportunities that are unique to Western Canada, from businesses in the industrial and agriculture sectors to Indigenous-owned enterprises, technology start-ups and emerging growth companies. Contact us to learn more.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.