A side letter is an agreement between a company and an investor in order to vary the terms of the limited partnership agreement. Like many things, including the wide world of fintech, technology is available that can smooth the process and make it easier for both sides to gain a win.
Troy Pospisil is Founder & CEO of InCloudCounsel, a global provider for processing routine legal work. Here he shares his thoughts on the importance of having a clear view of fund documentation and new innovations in tech that are allowing efficient ways of tracking, managing and complying with existing fund obligations.
In recent years, investors in private funds have increasingly required individualised agreements with their fund managers, known as “side letters”. These side letters often cover a broad range of topics including, but not limited to, prohibited investments (such as tobacco or firearms companies), preferred fee structures, and bespoke reporting requirements. As the number of side letters, and the number of terms in those side letters, continue to grow, fund managers are left with the challenge of organising, managing, and ultimately, complying with the obligations contained in those documents. Compliance with side letter terms involves cooperation and coordination from all functions at the fund manager including legal and compliance, finance and accounting, investor relations, and investment professionals. While large, multi-strategy asset managers can have thousands of active side letters at a time, even smaller fund managers are seeing a dramatic increase in the number of obligations they are required to manage. Failing to meet these investor obligations can lead to legal action, regulatory fines, loss of investor confidence, and reputational damage.
To date, fund managers have largely used a piecemeal approach to managing the growing numbers of obligations owed to their investors. For decades, funds have relied on a “compendia” of side letter terms prepared by their outside counsel. These compendia are often hundreds of pages long for each individual fund and lack the functionality to provide fund managers transparency across funds, categories of obligations, and investors. Moreover, these static compendia do not allow fund managers to assign owners to these obligations or drive accountability across the organisation. Other fund managers have tried to repurpose existing software like CRMs or accounting platforms but these tools lack a purpose-built data architecture to deal with the nuances of fund documentation, in particular, the most favoured nation (MFN) provision.
To address this growing need, fund managers are increasingly relying on new technology in order to actively manage their obligations to investors contained inside letters, limited partnership agreements, and other complex fund documentation. By turning these complex legal contracts into actionable data, technology allows fund managers to track compliance with ongoing obligations, analyse key provisions, and audit compliance with completed obligations, all from a single, centralised platform. Users can easily search their obligation data across funds, investors, obligation categories, and even functional owners within their organisation. These systems also function as workflow management tools, allowing fund managers to create a clear audit trail for internal compliance, investor requests, and regulatory exams.
The benefits of this new technology goes beyond compliance. For example, by having a clear understanding of the legal terms they have agreed to historically with their investors, fund managers can more effectively negotiate in future fundraises. This transparency streamlines negotiations, saves costs, and ultimately allows fund managers to close their funds faster.
Side letters are at the core of the relationship between investors and fund managers. To properly comply with these side letters, fund managers need a clear view into the full scope of obligations contained in those agreements, the ability to assign accountability for individual obligations, and a clear, centralised audit trail as evidence of compliance. While the number of side letters continues to grow, fund managers will need to leverage a purpose-built software tool to truly deliver on the many promises made to their investors.