Private equity continues to broaden its investor base, drawing in capital from institutions with increasingly specific requirements. Religious values, regulatory mandates, and reputational concerns now shape how and where some investors can participate. For fund managers, the challenge is to accommodate those constraints without compromising the fund’s structure or strategy.
Side letter agreements offer a solution. These individually negotiated documents allow funds to tailor certain terms for specific investors—without rewriting the main fund agreement. Whether it’s excluding certain sectors, enhancing transparency, or granting specific governance rights, side letters provide a way to bridge investor needs with fund uniformity.
Used effectively, side letters enable funds to secure capital from mission-driven or restricted investors while maintaining operational cohesion. They’re becoming a key part of how private equity adapts to a more complex and value-sensitive investment landscape.
Understanding the Fundamentals
How do side letters play out? Side letters are able to meet different needs without disrupting the overall investment structure. Various types of investors, from sovereign wealth funds to pension plans to religious organizations, can invest substantial capital while ensuring their participation complies with their specific mandates, regulations, or principles.
Consider a hypothetical private equity fund that invests in the technology sector. The fund comprises of conventional investors and one $300 million sovereign wealth fund that operates under strict governmental security restrictions. The standard fund agreement allows investments across the entire technology sector, but this presents a dilemma for the sovereign investor. Investments in certain defense-related technologies or companies with ties to specific jurisdictions are in violation of their investment regulations.
A side letter agreement solves this problem by creating a customized investment approach. It guarantees that the foundation’s money won’t support any practices or sectors it is mandated to avoid, while other investors in the same fund can still access the full range of opportunities. It’s a way to bring in more capital from value-driven investors without limiting the fund’s overall strategy. In short, it helps the fund make the most of its resources without compromising anyone’s principles.
Who Uses Side Letters and Why
From a fund perspective, the diversity of side letter users is a strength. These investors represent serious capital—and their needs are manageable when addressed correctly:
- Sovereign Wealth Funds often require side letters to comply with national security restrictions, sanctions, or other geopolitical considerations. They may need to avoid investments in certain countries or industries deemed sensitive.
- Pension Funds frequently use side letters to address fiduciary duties, regulatory requirements, or stakeholder concerns. They might seek enhanced reporting, governance rights, or restrictions on controversial sectors.
- Insurance Companies may require side letters to meet regulatory capital requirements or investment guidelines specific to their jurisdiction.
- Family Offices often negotiate side letters for tax optimization, succession planning considerations, or to align investments with family values.
- Endowments and Foundations use side letters to stay in compliance with their mission statements, donor restrictions, or institutional policies.
By adopting these tailored agreements, funds can attract mission-sensitive or restricted investors—without sacrificing agility or core investment principles.
Key Components of Side Letters
Well-structured side letters allow funds to align investor-specific needs with broader fund mechanics. Key components include:
- Investment restrictions: Tailored exclusions that limit certain sectors, jurisdictions, or practices.
- Excuse rights: Enabling investors to opt out of specific deals while maintaining broader participation.
- Enhanced reporting: Providing greater transparency on ESG, business practices, or other compliance metrics.
- Distribution mechanics: To ensure payouts are consistent with investor constraints.
- Governance rights: Such as consent, veto, or observation rights over specific matters.
These provisions enable funds to meet diverse investor mandates while staying operationally consistent and legally sound.
Practical Implementation Challenges
The operational challenges of side letters go far beyond drafting the agreements. Subscription credit lines—short-term loans secured by investors’ capital commitments—can become less reliable when some investors have excuse rights for various reasons. Excuse rights allow investors to decline participation in specific investments that conflict with their specific requirements, effectively removing their committed capital from those particular deals. Since those investors might not contribute capital to certain deals, lenders face uncertainty about how much money is actually available to back the loan.
This uncertainty makes it harder for lenders to assess risk, potentially limiting how much they’re willing to lend or making loan terms more restrictive. When a significant portion of an investment fund’s capital becomes “excused,” lenders may view the fund as riskier.
To protect themselves, lenders often include default triggers—conditions that allow them to demand repayment or stop lending if certain thresholds are met. Default triggers are contractual provisions that automatically activate when specific negative events occur, such as when available capital falls below a predetermined percentage of total commitments. Thus, if too much capital is excused, it could trigger a default under the loan terms, adding complexity to fund management.
An Evolving Tool
Side letters create an elegant solution for funds to work with restricted capital while staying aligned with their overall investment strategy. The effectiveness of side letters lies not just in their ability to accommodate different investor needs, but in their capacity to expand the overall pool of available capital for private equity funds.
By making investments accessible to a broader range of institutional investors, side letters help fund managers raise larger amounts of capital while ensuring that all participants can invest according to their specific requirements. When thoughtfully crafted, side letters lead to more aligned limited partners, stronger fund strategies, and a more inclusive and adaptable private equity marketplace.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
