Side Letter

A large institution committing Rs 200 crore to an AIF rarely accepts exactly the terms offered to a Rs 1 crore investor. It asks for something extra — a lower fee, a seat on a committee, a protection no one else has. Those extras are recorded outside the main fund documents, in a side letter.

The workbook explains that such arrangements "may not be generic to all investors but may be available only to a few institutional or large investors", so they are "recorded separately in supplementary documentation known as the side letter(s)". They are executed by the specific investor, the AIF and the investment manager.

In global practice, key constitutional and fund terms sit in the charter documents signed by all investors, while side letters are bilateral and not disclosed to other investors. That confidentiality is both their appeal and their risk.

Typical contents. Most often, side letters relate to:

• differential terms for the management fee;
• the working of the distribution waterfall;
• participation rights in investment committees;
• investor giveback.

Most Favoured Nation (MFN) clause. An investor may insist on a clause preventing any other investor from being placed in a better position than itself. The MFN clause lets the investor receive side letter entitlements to protect itself from less favourable terms compared with those offered to other current or future investors.

What should — and should not — go in one. Only terms requiring an individual right of action for the investor against the fund or manager, and not impacting the general operations of the fund for other investors, belong in a side letter, and they are worded so as not to be construed as prejudicial to others.

The fiduciary constraint. The manager owes a fiduciary duty to all investors. To avoid breaching it while giving large investors differential rights, most investment managers create a separate class of units with differential rights, issued to those investors.

Legal risk. Side letter enforceability has not been tested adequately in Indian courts, so the investor holding one carries some legal risk.

For the distributor or advisor. Side letters make it harder to assess risk for clients, because the advisor is unaware of preferential rights already granted to existing investors.

Illustrative figures. Sabarmati Credit Opportunities Fund, a Category II AIF, closes at Rs 1,200 crore. Its PPM fee is 2% a year on commitments during the commitment period.

A pension fund commits Rs 250 crore and negotiates a side letter, executed by the pension fund, the AIF and the manager, giving it:

1. a management fee of 1.5%;
2. an observer seat on the Investor Advisory Committee;
3. an MFN clause.

Fee at PPM rate  : 2.0% x Rs 250 crore = Rs 5.00 crore a year
Fee under letter : 1.5% x Rs 250 crore = Rs 3.75 crore a year
Annual saving    : Rs 1.25 crore

A year later, a sovereign fund commits Rs 300 crore at 1.25%. The pension fund's MFN clause entitles it to side letter entitlements no less favourable, so it can ask for 1.25% too.

To keep the arrangement within the manager's fiduciary duty to the other 40 investors, the fund issues a separate class of units carrying the reduced fee rather than simply granting it by letter.

Mr Joshi, a distributor advising an HNI on a Rs 5 crore commitment to the same fund, cannot see either letter. He knows only that larger investors may hold better terms — the precise difficulty the workbook flags for advisors.

Chapter 9 (Legal Documents and Negotiations — Investor Perspective) covers side letters at 9.4.1, immediately after the subscription (investor contribution) agreement, and the chapter's learning objectives list "Subscription Agreement and Side Letters" together. Expect questions on who executes a side letter, what it typically covers, the MFN clause, why managers use separate classes of units, and the untested enforceability of side letters in Indian courts.

• Parties: the specific investor, the AIF and the investment manager. Not the trustee alone, and not all investors.
• Side letters are not disclosed to other investors in global practice — they are bilateral.
• An MFN clause protects the holder against others getting better terms; it is not a right to the best terms in the market generally.
• Separate class of units is how managers avoid breaching fiduciary duty when granting differential rights.
• Enforceability is not adequately tested in Indian courts — side letters carry legal risk for the investor.
• Only individual-right-of-action terms belong in side letters, not terms that change the fund's general operations for other investors.
• A side letter is not the contribution agreement. The contribution agreement is between each contributor, the trustee and the manager and sets the basic terms; the side letter supplements it.