Side Letters

(Still) Front and Centre

(This is an update of our article, 'Side Letters – Front and Centre' published November 2017.)

In an earlier posting in this series of primers, 'Has the rise of the "lender friendly" LPA made an enemy of the side letter?', we explored a number of "lender friendly" provisions that are now going into limited partnership agreements. These provisions greatly assist lenders with making a credit decision on bridging investor commitments as they provide additional comfort that those investor commitments will be available to repay the lenders and ensure the efficacy of their security.

However, as the number of lender friendly provisions in LPAs has increased, so too has the number of side letters entered into with investors (and the breadth of issues they cover). Side letters supplement and modify the terms of an LPA in respect of the specified investor and in many cases cut across those friendly LPA provisions. What might appear to be a friendly set of constituent documents on its face, may be far from that once a close analysis of all side letters entered into with investors has been carried out.

As a subscription line / fund finance lender’s credit decision is based heavily on the contractual relationship between a fund and its investors, lenders need to be aware of any arrangements set out in side letters that may undermine such relationships; and in particular the obligation on investors to fund their capital commitments when called upon to do so. Accordingly we recommend that all side letters are reviewed by lenders as part of their due diligence process. As a general rule, a review of the side letters should identify terms which could adversely affect the lenders' right to payment, or which might release an investor from its obligation to fulfil its capital commitments. The following are a few of the points to consider when reviewing side letters:

1. Drawdown Notice Requirements

Side letters may specify that details over and above what is required in the LPA are to be included when drawdown notices are sent to investors, or may specify a very precise format that such notices must follow. Requirements that drawdown notices include specific breakdowns of investments, and/or specific confirmations from the general partner/manager are also commonly seen. Some side letters go even further than this and require that drawdown notices be signed by certain authorised signatories of the general partner or manager that have previously provided specimen signatures to the relevant investor(s).

Requirements such as these may cause concern for a lender as they would struggle to comply if they (or a security agent) needed to enforce but provided the issues are identified, solutions can usually be found.

2. Excused Investor Provisions

Investors often have investment policies limiting the types of investments that it may make. Where such policies do not align with the fund’s investment policies, they will likely be set out in a side letter so as to extend the circumstances in which that investor is to be excused from investing. Where an investor is so excused, it will not be required to advance commitments in relation to a drawdown notice for that purpose. Excuse rights have the potential to narrow the borrowing base of the fund. Lenders should be mindful that this may limit their recourse to investors and, with this in mind, funds should attempt to keep excused investor provisions as specific and narrow as possible. However, excuse rights should be reviewed in the context of the fund, its investment policy and shortfall provisions to understand their practical impact.

3. Overcall Limits

As LPAs become increasingly lender friendly, overcall limitations are often included in side letters rather than the LPA itself. Such limitations may restrict the percentage of a single investor's undrawn commitment that may be used to cover shortfalls due to the failure of other investors to fund or because other investors are excused from funding. As above, such limitations will need to be factored into borrowing base/financial covenant calculations, as the expectation is that all undrawn commitments will be available to repay any borrowing. (Special notice should be taken of the now common restriction on overcall for management fee/priority profit share.)

4. Sovereign Immunity

If an investor is a sovereign entity or other instrument of a government (e.g. a sovereign wealth fund or public pension fund), it may benefit from sovereign immunity. If an entity is so immune, it can prevent a party enforcing a judgement or claim against it. This is of concern to a lender as it (or a security agent on its behalf) could be prevented from enforcing a claim for that entity’s undrawn commitment. Sovereign immunity is a complicated area of law and specific jurisdictional legal advice may need to be sought if the intention is to include a sovereign investor in the borrowing base. It is usually beneficial from the lenders' perspective (and also that of the fund) if the side letter for such entity expressly states that such immunity will not compromise or otherwise limit the investor's obligations in respect of its undrawn commitment, although the enforceability of such a provision would need to be considered before a lender relied upon the same.

5. Disclosure Restrictions

Side letters may restrict the information that an investor is required to provide to the fund and/or to a lender. For example, it is now common to find that an investor is not required to provide any non-public financial information to any lender of the fund. We have also seen some side letters that go much further and provide that the fund may not disclose the identity or contact details of an investor to the lenders. This obviously poses great difficulties in putting in place a facility, so funds should seek to avoid/amend such a provision if there is such an intention.

6. Transfers

A lender will be concerned with how freely an investor may transfer its interest in a fund to a new investor as they will have completed their credit assessment and due diligence on the existing investors. It is common for transfers by investors to be subject to a form of general partner/manager consent pursuant to the LPA. Side letters however regularly include provisions diluting such consent rights, in particular as regards transfers to affiliates. Lenders need to understand the risk that such provisions pose, and ensure that any corresponding obligations imposed on the general partner/manager pursuant to the facility agreement (i.e. provisions that require the general partner/manager to seek the consent of the lender(s) in certain circumstances before consenting to such a transfer have teeth in practice).

7. MFN

Side letters may provide the ability for an investor to elect to receive the benefit of side letter provisions the fund has entered into with other investors. Lenders should be mindful of any such provisions, commonly referred to as most favoured nation ("MFN") provisions (which may also be set out in the LPA). Such provisions highlight the importance of reviewing all side letters pre and post financing as opposed to just a select few - a side letter from a minor investor outside of the borrowing base, admitted at an investor close after a facility is put in place could include a provision that is imported into multiple side letters by way of an MFN process. Drafting side letter provisions to be investor specific (and therefore not available under the MFN process) can prevent unexpected adjustments to the approved investor list/borrowing base following the MFN process.

8. Derogation from waiver of set-off

In our "lender friendly" primer, we noted that we increasingly see LPAs include a confirmation from investors that they will fund a drawdown request made to repay a facility by a lender without defence, set-off or counterclaim. Such a confirmation helps provide further assurance that nothing will cut across the lenders' reliance on undrawn capital commitments to repay the facility. That said, side letters may cut directly across this provision in the LPA. This derogation is often seen in the side letters of sovereign entities that cannot agree to such waiver as a matter of law. In this situation, funds should ensure that any provision in a side letter that derogates from the waiver is not subject to the MFN process.

9. Cease Funding Events

Side letters sometimes provide cease funding rights (a right to avoid meeting capital calls in specified circumstances without becoming a defaulting investor). Obviously any such right cuts directly across the credit decision of the lenders and, accordingly, there needs to be careful consideration of its inclusion if the intention is to have a subscription line. One solution is to ensure any such right does not apply to a drawdown notice made to repay a subscription line lender. Again, it will also be beneficial if this is only included where it is an investor specific requirement and is not subject to MFN rights.

Usually, solutions to the issues highlighted above can be found, but as the number of side letters increases, identifying each issue and creating a solution can take time. Funds have a difficult balance to strike when seeking to please both lenders and investors but providing an opportunity for lenders and their counsel to review constituent documents (both LPAs and side letters) before they are finalised will often help to alleviate the need for additional terms to be included in the facility agreement or an unexpected exclusion of investors from the borrowing base.

With special thanks to Elizabeth Street-Thompson, Associate, for her contribution.