Don’t sideline side letters | The Financial Express

Don’t sideline side letters

With the growing alternative assets industry in India, Securities and Exchange Board of India (Sebi) has also been increasing its oversight of Alternative Investment Funds

Don’t sideline side letters
As the alternative assets industry has grown in India, side letters have become an increasingly common feature in the Indian asset management market.

By Vivek Mimani, Partner, Khaitan & Co.

In the alternative assets industry, side letters form an essential part of negotiations between investors and the asset managers. Side letters are essentially agreements between a particular investor and the investment manager that provide the specific investor with different or preferential terms than those set forth in the fund’s governing documents, available to other investors. Side letters generally grant more favourable rights and privileges to a few preferred investors (e.g., anchor investors, strategic investors, those with large commitments, and large family offices etc) or to investors subject to government regulation. Investment managers typically enter into side letters with investors who either invest a large amount in the fund and/or bring some reputational advantage to the fund by means of their participation. As the alternative assets industry has grown in India, side letters have become an increasingly common feature in the Indian asset management market. 

With the growing alternative assets industry in India, Securities and Exchange Board of India (Sebi) has also been increasing its oversight of Alternative Investment Funds (AIFs). One of the by-products of this has been Sebi taking an increasingly dim view of side letter arrangements. For instance, the regulator, vide circular dated February 5, 2020, introduced a standard Private Placement Memorandum (model PPM), regulating side letters to some extent that was entirely unregulated earlier. In fact, based on certain recent news articles, it is possible that the regulator is even contemplating banning such arrangements.

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Concerns regarding side letters are not specific to the Indian regulator. Recently, the US Securities and Exchange Commission (the SEC) proposed new rules under the Investment Advisers Act of 1940. The draft rules propose to prohibit all private fund advisors from providing preferential treatment to certain investors in a private fund, unless the adviser discloses such treatment to other current and prospective investors. The SEC has also expressed concern while stating that such preferential terms do not necessarily benefit the fund or other investors that are not party to the side letter agreement and, at times, those terms can have a material, negative effect on other investors.

While taking into account the above views of the regulators, one has to acknowledge that side letters form a part of prevalent practice across alternative investments globally. This stems from the very nature of the product as an asset class for high net worth and sophisticated investors. Unlike mutual funds, AIFs are specially crafted for investors who have risk capital and are aware of the risks associated with the product, and who also have certain strategic reasons for partnering with a fund manager. These aspects are generally accommodated through the use of side letters.

Side letters provide significant operational and commercial flexibility to the investment managers. For instance, side letters enables the fund to excuse certain investors from specific investments on account of legal, regulatory or policy considerations that apply to such investors. These are especially relevant in the case of investors who are heavily regulated such as insurance companies or investors with an emphasis on environmental and social standards such as development finance institutions. Further, several funds also incorporate a limited partners advisory committee in which certain investors are granted seats basis side letters.

As far as monitoring any adverse impact of side letters goes, India is among the markets which has taken a lead in addressing this issue. For instance, the Model PPM prescribed by Sebi provides that investment managers shall state if any side letter shall be offered, the extent to which manager intends to offer side letters, and the criteria for offering differential rights through such arrangements to any investor. The Model PPM also provides that the terms of side letters shall not have any impact on the economic rights of other investors and that nothing under the side letters shall alter the rights of the other investors available to them under their respective contribution agreements. Further, the Model PPM also provides for certain terms not permitted to be amended through the use of side letters acknowledging that any amendment of such a term for a specific investor may adversely impact the rights of other investors (for example, terms relating to investor giveback).  Accordingly, while Sebi is making efforts to uphold the interests of the investors, keeping the global landscape in mind as well as the requirements of the industry, one would hope that appropriate guidelines are provided as opposed to clamping down on the practice of side letters.

While the intent of Sebi to regulate side letter arrangements may be right, it will need to strike a fine balance by ensuring that it should not lead to stifling of the flow of institutional capital into the AIF space. A good middle path could be the current approach on disclosure of side letter terms by the investment manager. This would provide investors an opportunity to inquire from the investment manager about any preferential rights granted to other investors before they make their commitment to the fund. 

(Co-authored with Rohit Jayaraman, counsel, and Shambhavi Sinha, associate,  Khaitan & Co.)

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First published on: 07-11-2022 at 05:00 IST