Side Letters and Special Treatment of LP's: Problems and Commentary

Joseph W. Bartlett, Founder of VC

Within the trade, concern is rising that the SEC will, sooner or later, be taking up the issue of the equitable treatment of investors in hedge funds and, because of the convergence (contamination in the minds of some) between hedge funds and private equity funds, perhaps the LPs in buyout and venture funds as well. The word at the moment is that the SEC is planning to review "undisclosed side letters" issued to favored investors in hedge funds ... an area of inquiry which may well segue into private equity funds generally. [1]

It is, of course, too early to scope out where the SEC's investigations may lead. However, it is not too early to anticipate problems of some size, shape and description and prepare for the same ... as sponsors and their advisers, including counsel, structure the LP agreements and review the private placement memoranda ("PPM"). (In fashioning this notation, let me pay credit to Martin Sklar of Kleinberg, Kaplan, Wolff & Cohen, PC, who led the discussion of a small private group of professionals which considered these problems in a recent roundtable discussion.)

Some of the problems which arise in this context include:

Problem One:

In the hedge fund universe, assume a side letter which allows a favored investor to shorten the time for redemption and/or to receive reports on a favored basis; this right could give the recipient an opportunity to get early warning of untoward developments ... and abandon ship before the rest of the investors get wise. The fact is that it is becoming increasingly difficult, on occasion, for investors to exit many hedge funds, at least in bulk. There are bells and whistles in the documents and practical hurdles the managing partners can (or may have to) impose which may make the stated redemption right, at least on a timely basis, more theoretical than real. Hence, the early bird catches the worm.

Problem Two:

Side deals which allow a particularly valuable investor to invest, despite the investment being below the stated minimum in the PPM or the partnership agreement (and there being no express waiver provision).

Problem Three:

A favored investor is given relief from language in the Partnership Agreement respecting, for example, confidentiality. The sponsors claim they will not allow anyone into the partnership who is subject to the transparency mandates recently imposed by State and Municipal employee benefit plans ... but make an exception for a favored plan.

Problem Four:

An investor, say, at the second closing is given assurance that, despite the stated leeway of the general partner to invest funds in, say, public securities or any single investment up to 15 percent of committed capital, the general partner will self impose restrictions which reduce the percentage leeway significantly ... from, say, 15% to 10%.

Problem Five:

Whether or not set out in a side letter, the question arises whether the practice of treating investors differently who or which default on their commitments is (i) forbidden, unless specifically authorized in the Partnership Agreement or PPM; and (ii) whether, if the GP does let a specific LP out without imposing any penalties for commitment default, the GP is under an obligation to report what it has done to the remaining investors. (GPs don't like to do this since notice could create "a run on the bank.") The hypothetical is that an investor defaults on its commitment and makes a plausible case for no penalty whatsoever; if the GP attempts to impose any default provision, the investor will take the original PPM apart piece by piece (particularly the braggadocio revolving around the GP's prior track record) and initiate 10(b)(5) proceedings, looking towards rescission rights. Note, in this connection, there is some case law to the effect that, every time a capital call is made, a new statute of limitation period starts for 10(b)(5) purposes.


There are, of course, no definitive answers to these questions. There has been no reported litigation with which I am familiar, although the roundtable discussion brought out a couple of cases which commenced and settled ... in one of which I participated (an arbitration). No trail blazers or road map cases, in other words; and of course, the SEC is only starting to make inquiries.

Among the questions to be reviewed are, for example, whether the 'no harm, no foul rule' does and/or should apply. If the Partnership Agreement recites that the management fee is 2% and the language contains no waiver authority in the GP, do the non-favored LPs lack the power to object because it is the management company, not the partnership, which suffers as a consequence when LP X gets to put in less than its share? In one case in which was involved, the Partnership Agreement is very explicit and with no exceptions indicated; we wrestled with the question whether one of the unfavored LPs could argue that, if any unconditional provision of the Partnership Agreement is to be amended ad hoc, it is necessary for the GP to follow the very specific amendment provisions in the Agreement, which typically require a vote of the LPs. Should there be an exception on the basis of 'no harm, no foul?' What is the situation if, anticipating the problem, the MFN [2] LP in fact pays the full management fee, and then the management company reimburses it in like amount.

The same argument ensues if the Partnership Agreement states that the partnership will invest no more than 15% of its total commitments in any one company and one LP, through the device of a side letter, ratchets that percentage down 10%. Have the non-consenting LPs been damaged in any way? It can be argued that, if (as is necessarily the case) any LP has the right to demand disclosure of side letters, perhaps the LPs investing along side the MFN LP cannot complain ... certainly if they see the side letter and still invest. And, perhaps they are estopped if they [could have seen it and did not ask. However, how about the LPs who invested at the initial closing, assuming the side letter surfaces only at the second closing?

Assume again a specific provision in the Partnership Agreement (hypothetically the 15% constraint on the investment in any particular portfolio firm) has been reduced de facto by a promise to an MFN limited partner? Or another, and perhaps more troublesome, provision states that no limited partner can withdraw (subject to specified instances ... the ERISA kick out rules, for example) and an offshore partner, an MFN, obtains a special, omnibus right to reduce its commitment if circumstances in the home country change to the point the investment is subject to "unfavorable domestic tax consequences." Assume no one thinks to ask to see the side letter and it is not voluntarily disclosed; is the existence of such a provision in a side letter a "material fact" which would give any uninformed investor a right to redeem on the theory that the disclosure materials ... the PPM accompanied by the Partnership Agreement ... omitted or misstated a material fact, i.e. , the apparently unqualified, all-encompassing rule. Assume that the PPM mentions nothing about the general partner's right to issue side letters and/or an LP's right to insist on disclosure of all side letters. Does the GP, controlling the Partnership, have a "fiduciary duty" to treat all partners "fairly." Note that, under the recent Delaware amendments to the LLC and LP Acts, "fiduciary duties" can be excised by agreement but not the residual duty of "good faith" and "fair dealing."

Continuing with troublesome cases, assume, in the hedge fund universe, an MFN hedge fund investor has the right to more prompt information than its fellow investors and the MFN investor gets out early, before the other investors are apprised of a negative development. Is this right, assuming it is exercised, the equivalent of trading on the basis of material, non-public information? If there is any area the SEC is liable to review, it strikes me that discriminatory distribution of information would be the likeliest candidate to excite the Agency's initial curiosity.

Turning back to the private equity fund business, are there any prophylactic and precautionary steps to avoid trouble before it occurs? It would appear such is certainly the case. Some personal nominations.

Looking at the PPM first, if side letters are to be issued on an MFN basis, it would appear prudent were the PPM should say so ... perhaps even coming up with some examples which illustrate the type of issues which might be the subject of the side letter. The basis for the side letters also could well be outlined ... keyed, for example, to the size of the investment, analogous to "volume discounts" as some professionals argue. The investors/LPs can be alerted that they have the right to ask for the disclosure of side letters and, if they do not, they will be deemed to have waived an action against the general partner or the management company on the basis of side letter provisions. This may not, of course, protect the initial investors if the side letter is issued, and alters the Partnership Agreement in favor of an MFN, at the second closing; but, the PPM at the first closing could mention the possibility of a side letter that would alter the document at a subsequent closing.

It also could be helpful to expand and specify the general partner's waiver powers, side letter or no side letter. For example, if the GP for any reason whatsoever wants to impose a lesser, penalty, or no penalty whatsoever, on a defaulting partner, it should state specifically it has the ability to do so ... and keep the process to itself. In that connection, of course, in most, but not all, cases disclosure of the default will ultimately occur when the financial statements become available and the accountants note the changes in, say, capital accounts or footnote changes in the capital commitments. [3]

These issues are on the screens of the SEC and the practicing bar. Any comments? Please send to

[1] Mike Halloran, who writes on these subjects as prolifically as I, was good enough to comment that, in his view, the SEC intervention is far off. Given the slow down (driven by Enronitis preoccupation) by the SEC in other areas ... "general solicitation" and "finders" as broker/dealers, I will not quarrel with Mike's thesis.

[2] The term MFN ("most favored nation") is used, variously, to describe an LP/investor which negotiates a genuine MFN letter ... "I get as much as anyone else" ... or simply to refer to the beneficiary of a side letter.

[3] See Dec. 2004 [Private Equity Bulletin: "The GP's Fiduciary Duty Can Now Be Eliminated in Delaware Limited Partnerships, We Think." If the penalty is a forced secondary sale at a discounted price, maybe to an MFN LP, there may be no disclosure.