A number of private equity funds and hedge funds are structured as limited partnerships that are governed by the terms of a limited partnership agreement (an ‘LPA’). A recurring theme in private equity fund investing is the use of ‘side letters’ between individual limited partners and the general partner of the fund. Side letters can range in scope from administrative matters to providing substantive rights to limited partners. Questions and issues inevitably arise as to the type of provisions that can be included in a side letter (which, in most cases only benefit the recipient of the side letter) as opposed to being incorporated into the limited partnership agreement itself (which generally benefit all limited partners of the fund).
As two commentators have noted in their paper when discussing the existing case law that addresses side letters, “there are almost no reported cases, and the cases that do exist are generally illustrative only by analogy. Even then, the results are, as the analysis of side letter terms should be, as well, extremely fact-specific.” 1 Indeed, as of the date of this article there is no Canadian case law on point that specifically interprets side letters issued to limited partners pursuant to the terms of a limited partnership agreement.
Notwithstanding the lack of any clear direction from Canadian courts on the subject, the major issues surrounding side letters can be classified into three general areas: (i) how the LPA treats the issuance of side letters, (ii) what provisions are appropriate to include in a side letter regardless of the express terms of the LPA, and (iii) disclosure of the side letter to limited partners.
Treatment of side letters under the LPA
In general, LPAs may (i) be silent on the ability of the general partner to issue side letters, (ii) contain blanket provision that permits side letters to be issued, or (iii) contain an express provision that permits side letters to be issued but also governs certain aspects of side letters, including, among other things, the extent to which a side letter may be inconsistent with the terms of the LPA and whether other limited partners are entitled to the benefits of any particular side letter that may be issued from time to time.
Appropriate provisions to include in side letters
At present, there is very little guidance or authority on the types of provisions that can be included in side letters, and consequently the options appear to be almost limitless. While such flexibility and freedom permits general partners and limited partners to strike their own commercial deal, there are some practical concerns with an ‘anything goes’ approach to side letters. These practical concerns are grounded in questions of fiduciary duty and contractual interpretation in light of inconsistency between the LPA and a particular side letter.
A general partner in Canada is generally viewed as having fiduciary duties to the limited partners. Such duty would typically include an obligation for fair dealing with limited partners. To the extent that there is a side letter in favour of one or more limited partners, there is a question as to whether the general partner is dealing fairly with all limited partners. It is suggested that appropriate disclosure, and preferably specifically addressing side letters in an LPA, would significantly reduce any risks of any allegations by limited partners against the general partner that it breached its fiduciary duty in connection with the issuance of any side letter, subject to the following with respect to inconsistency between side letters and the terms of the LPA.
The relationship between the general partner and limited partners is generally governed by the LPA, which is a multilateral agreement between all partners. To the extent there is a bilateral agreement between the general partner and one or more particular limited partners which is inconsistent with the terms of the LPA, there is a question as to how any level of inconsistency would be interpreted by a Canadian court. Not surprisingly, it is likely that any decision would be highly fact specific. However, it is suggested that there are levels of inconsistency which are more likely to be tolerable than others.
At one end of the spectrum, side letter requirements which do not affect other limited partners (other than in an immaterial manner), such as extra reporting requirements, are not likely to raise judicial concerns regardless of whether the LPA expressly addresses inconsistency between an LPA and side letters. At the other end of the spectrum, side letter provisions which clearly and materially affect other limited partners should be carefully considered, even if the LPA provides express permission for inconsistency between the LPA and side letters. For example, an LPA for an infrastructure fund may state that it is intended to invest broadly in North American infrastructure across various sectors. If the general partner of such infrastructure fund proceeded to issue a side letter requiring that the fund only invest in one narrow infrastructure sector in one country, such side letter would significantly alter the overall nature and character of the fund. In such circumstances, one could envision a Canadian court viewing such a provision differently than a provision that simply provides for extra reporting requirements. Numerous other types of terms lie in between the two ends of the spectrum, and it is suggested that each term proposed for inclusion in a side letter be considered in light of this spectrum.
Further considerations also arise in connection with how side letters are disclosed to limited partners, if at all (especially where side letter provisions may affect other limited partners) as well as broader considerations on the types of disclosure that may be made to limited partners, as further discussed in part below. General partners also need to weigh the effect of subsequent side letters on existing limited partners, especially if a subsequent side letter materially alters the nature of the fund, and therefore materially alters the basis on which the previous limited partners invested in the fund. Such an analysis may take into account, among other things, the passage of time as between the investment by the previous limited partners and those who are obtaining the benefit of such a side letter.
LPAs that permit side letters may regulate the ‘how and when’ side letters are to be disclosed to other limited partners. Not surprisingly, certain securities regulatory agencies and private equity/hedge fund industry groups and associations have developed general positions relating to the disclosure of the existence of side letters between limited partners. For example, the Task Force to Modernize Securities Legislation in Canada recommends that any regulatory regime applicable to hedge funds require “mandatory disclosure of any 'side letter' and other collateral agreements between the hedge fund and investors who receive special fee or liquidity arrangements.” 2
The Managed Funds Association (MFA), a U.S. industry body, recommends that hedge fund managers should disclose to investors side letters granted to preferred investors that have a ‘material impact’ on other investors. 3 The Asset Managers’ Committee, a U.S. industry body, suggests that “in circumstances where side letters may adversely impact other investors in the fund, the Manager should make such disclosure as may be reasonably necessary to enable other investors to assess the possible impact of such side letters on their investments.” Examples of side letters that may adversely impact other investors are: (a) enhanced control rights (over investment decisions or key personnel), (b) preferential liquidity/redemption rights (key personnel provisions and redemption ‘gate’ waivers), (c) the availability of preferential fees, and (d) terms that materially alter the investment program disclosed in the fund’s offering documents. 4
In the United Kingdom, the Financial Services Authority published disclosure requirements that requires Managers to ensure that all investors are informed when a side letter is granted, although Managers are not required to disclose the nature of the side letters. 5 In 2006, the Alternative Investment Management Association (AIMA), a U.K. industry body, recommended that the existence of side letters containing ‘material terms’ should be disclosed, as well as the nature of those terms (in other words, the topic of the side letter should be disclosed but not the actual content of the side letter). The AIMA defines ‘material term’ as including any term that is reasonably expected to put other shareholders at a material disadvantage. Examples include grants of preferential exit rights and portfolio transparency rights. 6
The European industry appears to be adopting a disclosure policy whereby the existence of material terms in side letters is made available to all investors. 7
It remains to be seen how courts in Canada will treat and interpret such side letters in the context of LPAs. However, the use of side letters in private equity funds and hedge funds will likely continue as a feature of the industry for years to come as general partners and limited partners continue to shape their relationships through them.
Rob Blackstein is an associate in Gowlings’ Toronto office, practising in the area of business law with a transactions-based practice focusing on mergers and acquisitions, corporate finance and private equity. Rob has advised corporations, investment funds and other clients in numerous cross-border transactions in multiple industries, including energy and infrastructure as well as mining. Rob articled with Gowlings after obtaining his JD and his LLB, and has successfully completed the Canadian Securities Course offered by the Canadian Securities Institute.
Myron Dzulynsky is a partner in Gowlings’ Toronto office Business Law Department, a member of the Executive Committee of the Firm’s Energy, Infrastructure and Mining Group, and a former leader of the Private Equity and Venture Capital National Practice Group. Myron's practice encompasses various aspects of business law, including private equity fund formation and downstream investments on behalf of private equity funds and institutional investors. He has advised a wide range of Canadian, U.S. and international clients in various sectors, including energy and infrastructure, manufacturing, financial services, retail, technology, real estate, intellectual property and gaming. Myron’s advice is often sought out by both clients and other Firm members for difficult structuring issues, particularly those involving partnership, cross-border or tax-driven elements. He is considered an expert in partnerships and limited partnerships, and has spoken on this subject both internally and externally. He is also on the Editorial Board for the Gowlings’ book The Electricity Industry in Canada. Over the past years, Myron’s practice has included a significant number of transactions relating to the infrastructure and energy sectors. He has acted on PPP transactions across Canada and internationally on behalf of debt and equity providers, on fund structures and investments into funds, and on secondary market transactions.
Gowlings is one of Canada’s largest law firms, with over 750 professionals in offices across the country and in Moscow, London and Beijing. Recognized for excellence in business law, advocacy and intellectual property law, Gowlings offers dedicated industry expertise in a number of sectors including energy, mining, infrastructure, life sciences, government, financial services, technology and manufacturing, and in areas such as corporate finance and M&A, transfer pricing and tax, patents and trade-marks, and occupational health and safety. The firm provides legal services in Canada, the U.K., and Russia and the CIS through the entities Gowling Lafleur Henderson LLP, Gowling Lafleur Henderson S.E.N.C.R.L., s.r.l., Gowlings (UK) Inc., and Gowlings International Inc. In 2011, the firm opened the Gowlings International Inc. Beijing Representative Office. For more information, please visit www.gowlings.com.
This article first appeared in Private Equity @ Gowlings (March 2012, Volume 3).
1Lahiri, Yasho and Reuben Kopel. “From Side Show to Center Stage: The (Sometimes Overstated) Perils of Side Letters”,Bloomberg L.P., 2006.
2The Task Force to Modernize Securities Legislation in Canada. Canada Steps Up, October 2006.
3Sklar, Ryan. “Hedges or Thickets: Protecting Investors from Hedge Fund Managers’ Conflicts of Interest”, 77 Fordham L. Rev.
4Asset Managers’ Committee. “Best Practices for the Hedge Fund Industry, Report of the Asset Managers”, Committee to the President’s Working Group on Financial Markets, 15 January 2009.
5Financial Services Authority. “Feedback Statement FS06/2, Hedge Funds: A discussion of risk and regulatory engagement”, March 2006; Levensfeld Pearlstein, LLC. “Hedge Fund Side Letters”, 10 July 2008.
6Levensfeld Pearlstein, LLC. “Hedge Fund Side Letters”, 10 July 2008.
7Naik, Narayan. “Hedge Funds: Transparency and Conflict of Interest”, Policy Department, Economic and Scientific Policy, European Parliament