Side Letters - Front and Centre

A fund finance or subscription credit facility (a "Facility") is a facility where the underlying credit decision of the lenders is based on the contractual relationship between the fund and its investors and in particular the undrawn commitment of investors in the fund and their obligation to put money into the investment vehicle when called upon to do so.  A side letter supplements and modifies the partnership agreement of a fund vis-à-vis the relevant investors' rights and obligations and so can go to the heart of the lenders' credit decision.  Side letters may give rights to an investor in addition to what is included in the partnership agreement and/or include terms which cut across the lenders' recourse to the undrawn commitments of the fund and can impact the security which is put in place to benefit the lenders.  

Side letters are becoming increasingly complex with a wider range of provisions to meet investor demands.  Recently when acting for the lenders our fund financing team has come across a few side letters that clearly had not contemplated putting a Facility in place and that meant a Facility was not possible without renegotiating the terms of those side letters with the relevant investors.¹ This is at the extreme end of the spectrum as solutions can usually be found to the issues posed by side letters. However, there are a number of common provisions which may impact lenders' credit decisions and funds should be considering these provisions when negotiating side letters with investors.  Lenders also need to be aware of any arrangements set out in side letters that may undermine their ability to enforce security.  Accordingly we recommend that all side letters are reviewed by lenders as part of their due diligence process.

As a general rule, review of the side letters should identify terms which could adversely affect the lenders' right to payment or which might release an investor's obligation to fulfil its obligation to fund its undrawn commitments.  The fine detail of the language and how  it might impact the lenders' credit decision needs to be considered.  A few points we recommend both funds and lenders look out for in side letters include:

1. Drawdown Notice Requirements:  Side letters may put extra requirements on what needs to be included with a drawdown notice to investors or specify a very precise format.  In many cases it would be difficult for the lenders to comply with such requirements (e.g. the inclusion of specific breakdowns of all investments or specific confirmations from the general partner or alternative investment fund manager ("AIFM")) should they ever have to enforce their security and issue drawdown notices. They can also include a requirement that drawdown notices issued by the general partner or AIFM be signed by certain authorised signatories of the general partner or AIFM who have provided specimen signatures to the investor. The concern for the lenders is that if ever they exercise their assigned rights under the security, they will not be able to issue a drawdown notice to such investors which is signed by such an authorised signatory of the general partner or AIFM. Usually, solutions can be found to these concerns based on the specific language in the relevant side letter. However, keeping in mind the obvious concerns of the lenders with these provisions when agreeing the side letters (and, for example, drafting such a requirement as a contractual obligation of the general partner or AIFM with failure to comply not affecting validity of the drawdown notice) will ease putting in place a credit facility.
2. Sovereign Immunity:  If an investor is a sovereign entity or other instrument of a government (e.g. sovereign wealth funds or public pension funds), it may have certain rights to sovereign immunity which result from its status as such an entity.  Sovereign immunity can prevent a party enforcing a judgement or claim against such sovereign entity.  From the lenders' perspective, they could be prevented from enforcing against a sovereign entity investor for its undrawn commitment.  There can be exclusions to sovereign immunity, for example in respect of 'commercial transactions', and some sovereign entities have the ability to waive such rights.  This is a complicated area of law and specific jurisdictional legal advice should always be sought in this regard if such an investor is to be included in the borrowing base.  It is usually beneficial from the lenders' perspective (and also that of the fund) if the side letter 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 relying upon the same. It is often also possible to exclude from sovereign immunity the enforcement of contractual obligations under the partnership agreement generally, although again, such a provision would need to be carefully considered before relying upon it.
3. Placement Agent Policy and Cease Funding Events:  Following alleged corrupt practices, a number of investors now seek to limit the use of placement agents. Often this is reflected in side letters by the general partner or AIFM making several representations, warranties and acknowledgements in respect of that particular investor's placement agent policy.  Often, if the general partner or AIFM fails to comply with this policy the investor will be entitled to cease funding their undrawn commitment to the fund and the general partner or AIFM will not be able to take any action against that investor for being a defaulting investor.  If such a cease funding event occurs, it would completely undercut the lenders' credit decision made on that investor. Often (but not always), lenders can get comfortable with this particular cease funding event as the likelihood of a breach is seen as extremely remote. However, we have recently seen some extensions to cease funding events to areas other than simply placement agent policies. These need to be considered carefully. One simple solution we have seen is a side letter that provides a cease funding event applies to all further drawdown notices except for a call made to repay a subscription credit facility.
4. Disclosure Restrictions:  Side letters can restrict the type of information that an investor has to provide to the fund and to the lenders.  For example, it is now common to see a provision that provides 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 (but not necessarily insurmountable) difficulties in putting in place a  Facility and general partners of AIFMs should seek to amend such a provision if there is an intention to put a Facility in place.
5. Excused Investor Provisions:  Investors often have various investment policy provisions which will be set out in side letters.  These will extend the circumstances in which that investor is excused from investing in certain assets and as such that investor would not be required to advance commitments in respect of investments which are contrary to its policies.  The expansion of excuse rights has the potential to narrow the borrowing base of the fund under a Facility.  Lenders should be mindful that this may limit their recourse to investors as they will be excused from funding their undrawn commitment under these circumstances and for the fund it is therefore important to keep excused investor provisions as specific and narrow as possible.  However, any prohibited investments leading to excuse rights should be reviewed in the context of the fund, its investment policy and shortfall provisions as the risk of any conflict may be minimal.
6. Transfers:  Lenders will be concerned with how freely an investor may transfer its interest in the fund to a new investor.  As they will have completed their credit assessment and due diligence on the existing investors, lenders will be wary of investors with whom they are unfamiliar and have not made a specific credit decision.  It is common under partnership agreements for transfers by investors to be subject to a form of general partner or AIFM consent.  Side letters regularly include further watering down of the general partner's or AIFM's consent rights in particular as regards transfers to affiliates.  Lenders need to be certain they understand any risk that the consent right in the side letters (and limited partnership agreement) poses and that any obligation in respect of investor transfers it imposes on the fund under a Facility actually has teeth through the general partner's or AIFM's rights under the fund documents.
7. Overcall Limits:  Overcall limitations are increasingly included in side letters rather than the partnership agreement.  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.  Again, any such limitations will need to be factored into borrowing base/financial covenant calculations in a Facility as the usual expectation is that all undrawn commitments will be available to repay any borrowing.
8. MFN:  Side letters can provide that an investor may elect to receive the benefit of more favourable provisions from side letters the fund has entered into with other investors.  Lenders should be mindful of any most favoured nation ("MFN") provisions (which may also be set out in the partnership agreement).  This highlights why it is important for lenders' counsel to review all side letters and not just a select few as even a side letter from a minor investor outside the borrowing base can include a provision that becomes incorporated into multiple side letters by way of the MFN process.  Similarly, side letters entered into as part of subsequent closes/after entry into a Facility may include a provision that becomes incorporated into multiple side letters and so should be reviewed by lenders' counsel.

It is always a difficult balance for funds in considering the time and cost of bringing in their potential relationship lenders (and their lawyers) while negotiating side letters with their investors versus presenting a fait accompli to the lenders and hoping there are no concerns. Providing the opportunity for a lender and its counsel to review 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.