Know what to ask for in side letters when co-investing

Article content

Side letters are becoming an increasingly common way for investors and private equity funds to lay out the terms of a co-investing deal, but they can be complicated. Knowing what to ask for could mean the difference of having a say in your investment and leaving some privileges on the table, according to legal experts.

On the other hand, coming to the table with reasonable and well-informed asks makes one an ideal and attractive co-investor, which is an advantage for anyone trying to get into these types of investment deals in the competitive private equity market.

The first piece of advice is to get specialized counsel from someone who deals with these sorts of contracts – even if it means going outside the in-house shop.

“I think it’s really critical for a family office to build out their internal team and their external legal and financial advisors,” cautions Angela Austman, a partner at Lawson Lundell LLP with a speciality in private equity investment review. “It’s a focused experience in this type of investing because it is so highly specialized and it is a bit of a black box and it’s much more than just writing a cheque.”

“They’re there to support, but they’re also there to suggest things that the co-investor may not have thought of,” says Kim Le, co-head of the mergers and acquisitions and private equity groups for Stikeman Elliott LLP in Toronto. “Or be creative about the types of solutions or middle ground that you can get to negotiate.”

These letters go beyond the business of the amount a co-investor will contribute to a deal or how big of a share one may have in a deal, but these factors can play a significant role in what might be an option to propose in a side letter. The bigger the cheque, the more leverage and possibilities one may have.

Examples of what to ask for in a side letter

While there are too many asks to list, it may be helpful to see what kinds of options are available in a side letter.

One common aspect in a side letter is better access to information, such as an obligation by a general partner to tell you if there has been any material changes to the funds or business, explains Austman. She says that this can include things like a material breach of the limited partnership agreement, a change of auditor that might indicate there is an issue, material litigation or a material indemnification claim.

“You could negotiate a right to be told on a timely basis about those things,” says Austman, adding that how many provisions you may be able to get in your side letter is often dependent on how much money one is contributing to the co-investing deal.

“If an investor is asking for a particular side letter provision, like, let’s say, ‘You will tell me if there’s materialization,’ these fund sponsors may say, ‘Sorry, we only give that disclosure right to investors that are cutting more than a $20 million cheque.’

A seat on the board might also be an option in a side letter, but it is important to negotiate that up front and realize that there are other options even if a board seat is not on offer.

“You can negotiate to have an observer,” says Le. “In this case, an observer gets to attend all the meetings, but not necessarily to vote, but at least you’ve got a bit of a closer eye on your investment.”

She adds that one can also negotiate the opportunity to ask questions to some of the key fund managers, or have access to the financial reports that are given to directors, or access to the budget – all specific side letter asks.

“The primary reason that you prefer to be a co-investor, rather than just an LP [limited partner] is that you really do get a little bit of a better deal around the economics,” adds Le. “In a side letter, you can negotiate, for example, that you get a cut of the private equity funds carry, or you get better governance terms. That’s why it’s so important to have the right counsel.”