Side Letters: The Terms Not Everyone Gets

A side letter is a separate agreement between the fund and one investor, signed alongside the same contribution agreement everybody else signs. A side letter gives that one investor something the others did not get: a committee seat, an excuse right, extra reporting, a transfer right, or a right to elect into terms granted to another investor. The letter binds the fund and leaves the memorandum alone.

A familiar case makes the shape of it clear. Twelve neighbours put money into a shared borewell for a lane, all on the same written understanding, and then one of them, the one who paid for a fifth of it, quietly gets a separate note saying she will be told before the pump is switched off for repair. Nothing in the shared understanding changed. Nobody else's water changed. One person now knows something first. A separate note of that kind is almost exactly what a side letter is. Some of these notes cost the other eleven neighbours nothing at all, and some of them quietly move money. Telling those two apart is the whole skill, and the size of the concession never shows which of the two a given letter is.

The fund used throughout is Nilgiri Growth Partners Fund II, an invented vehicle managed by Nilgiri Alternatives Advisors Private Limited. The fund has twelve investors who committed Rs 4,90,00,00,000 between them, and the manager committed a further Rs 10,00,00,000 of its own, so total commitments are Rs 5,00,00,00,000. Six of those twelve investors hold a side letter. Each figure attached to the fund belongs to the period stated beside it.

What is a side letter, and where does it sit against the documents everybody else signed?

Three documents matter and they do three different jobs. The placement memorandum describes the fund to everybody who is thinking about coming in: the strategy, the terms, the parties, the risks. The contribution agreement is what an investor actually signs to become an investor, and in Nilgiri Growth Partners Fund II all twelve signed the same one. A side letterA separate agreement giving one investor terms the others did not get. is a third document, signed by the fund and by one investor only, that varies what that agreement means for that investor and for nobody else.

Notice the shape of that. A side letter does not amend the partnership terms for the group; it sits beside one investor's copy of the deal and changes that copy. The memorandum the other eleven investors read stays exactly as it was printed. The separation is what makes the practice possible at all: a fund can give one investor a committee seat without reopening the offering document, without a vote, and without every other investor being asked to agree. The same separation is why a side letter repays close reading. A document can change one person's deal without anybody else being told.

In this fund the general partner's role is discharged by the manager and the trustee between them, and the contract stack is a trust deed and a contribution agreement rather than a partnership agreement, so the side letter here is a letter countersigned by the manager and the trustee. The contents of the placement memorandum, and how terms sit inside it, are covered separately.

Why does a fund sign one at all, and who ends up holding them?

Because raising a fund is a sequence of separate negotiations, not one auction. A manager goes out to raise Rs 5,00,00,00,000 and speaks to institutions one at a time, over months. Each of them arrives with its own constraints, and some of those constraints are not preferences at all. A treasury may be forbidden by its own internal mandate from being exposed to a particular sector. A regulated insurer may need a specific confirmation in writing before its own supervisor will let it report the position. A large institution may need to be able to move the holding to a sister entity if it reorganises itself. None of those requests is about wanting a better deal. Each of them is about being able to sign at all.

When the alternative is that a particular investor cannot come in, the fund signs a side letter, and it signs the ones it is willing to live with. The common picture is different: large investors extracting concessions because they can. Bargaining position is real, and it does sit with size, but the record of this one fund shows how loosely the two track each other.

Read the picture slowly. The ranking kills a lazy rule. Investor 1 committed Rs 1,00,00,00,000, being 20.0 per cent of the fund's Rs 5,00,00,00,000 and 20.4 per cent of the Rs 4,90,00,00,000 the twelve investors committed between them, and investor 1 holds a letter. So does investor 8 at Rs 20,00,00,000, or 4.0 per cent of the fund. So does investor 12 at Rs 5,00,00,000, the smallest cheque in the vehicle, or 1.0 per cent of the fund and 1.0 per cent of investor commitments. Meanwhile investor 2 at Rs 75,00,00,000, the second largest of the twelve, holds nothing at all.

Two things explain that pattern and neither of them is negotiating skill. First, several of these letters answer a constraint rather than a preference, and a constraint does not scale with the size of the cheque: investor 8, a domestic pension pool at Rs 20,00,00,000, wanted to be told if the manager's team composition changed, and that request is the same request whatever the cheque is. Second, and this is the one readers miss, investor 12 is not an investor negotiating with the manager at all. Investor 12 is a co-investment vehicle for the manager's own senior staff, and its letter was not extracted from the fund; the manager wrote it for its own people. A letter is evidence that somebody had a reason the fund accepted, not evidence that somebody drove a hard bargain.

What do the six letters of one invented fund actually grant?

Here is the whole set, numbered as the fund's own record numbers them. Read the grants first and resist sorting them. The sorting is the part that takes work.

Which of these move money between investors, and which do not?

The split between the two piles is what matters, so state the test before applying it. A side letter moves economics when a rupee that would have belonged to one party now belongs to another; it does not move economics when it changes only what an investor is told, when it is told, what it may be left out of, or where it may move its holding to. Reporting, notification, transfer and consultation are all in the second pile. Fee, carried interest, preferred return and the order of distributions are all in the first. The test is not whether the term is valuable to the investor who got it. Information is valuable. The test is whether the rupees in the fund end up divided differently.

Sort the six on that test and the answer is five and one. Letter 1's committee seat and letter 5's notification are governance and information. Letter 2's extra reporting is information. Letter 3's regulatory capital confirmation is a statement about facts that already exist. Its transfer right lets one investor hand its interest to a sister entity, so the name on the register changes and the split does not. Letter 4's co-investment right of first look points at money that is invested outside the fund entirely, so the fund's own arithmetic never sees it. Letter 6 is the only one that touches what somebody pays.

Letter 2's excuse right is the interesting case and it belongs in the second pile for a reason worth spelling out. An excuse right changes which investors fund a particular investment, so it plainly changes something. The excused investor gives up the outcome of that investment along with the cost of it, and no value passes from one investor to another. If the deal turns out well, investor 3 has no share of it. If it turns out badly, investor 3 has no share of that either. Nobody is subsidising anybody; the exposures simply differ.

What does a most-favoured-nation right actually do?

A most-favoured-nation right is the clause that stops the practice pulling the fund apart, and it is the one term worth being able to explain from memory. Left alone, side letters fragment a fund: twelve investors, six private variations, and nobody except the manager knows what the deal actually is. A most-favoured-nation rightA right to elect into terms granted to another investor, on stated conditions. pushes back on that by letting a qualifying investor see terms granted to somebody else and take them for itself.

The right is not automatic. A most-favoured-nation right does not level terms by itself; it runs a sequence, and every step of that sequence can fail. A term has to be granted, the fund has to disclose it, the holder has to qualify under the size condition in its own letter, and the holder has to make an electionThe act of choosing to take up a term another investor was given. within whatever period that letter sets. Break any link and the term does not travel.

Two of the six letters carry such a right, letter 1 to investor 1 and letter 4 to investor 5. Only letter 1's condition is set out in the fund's record, and it is a size condition: investor 1 may elect into any term given to a later investor of the same size or smaller. Since investor 1 committed Rs 1,00,00,00,000, the largest cheque in the vehicle, all eleven of the other investors sit at or below that line, so by size alone its right reaches every one of them. Letter 4's right is named in the record without its condition, so what conditions that right is unknown.

Now the part that is easy to miss. Nilgiri Growth Partners Fund II holds six letters and no more, and no term was ever granted to a later investor, so neither most-favoured-nation right has produced a single election to the record date at the end of Fund II Year 9 Quarter 2. The right is real, the sequence is real, and in this vehicle it has never fired. A right that has never fired is not a defect. A clause that exists to prevent something looks exactly like this when the thing has not happened.

How far does a size condition let a term travel?

Bands are how these rights are bounded in practice, and the arithmetic is worth doing once because it shows how much work a single threshold does. Take the twelve investors of this fund and ask, for four illustrative thresholds, how many of them a right banded at that level would reach and how much money those investors represent. The bands below are illustrative and are not this fund's terms; the only condition the record states is the one in letter 1.

The second and third rows are worth comparing. Dropping the threshold from Rs 50,00,00,000 to Rs 25,00,00,000 brings only two more investors inside it, investor 6 at Rs 40,00,00,000 and investor 7 at Rs 25,00,00,000, but the money reached climbs from Rs 3,65,00,00,000 to Rs 4,30,00,00,000. The same money produces two different percentages depending on the denominator. Rs 4,30,00,00,000 is 86.0 per cent of the fund's Rs 5,00,00,00,000 of total commitments, and 87.8 per cent of the Rs 4,90,00,00,000 the twelve investors committed between them. The manager's own Rs 10,00,00,000 sits inside the first denominator and not the second. A share of the fund and a share of investor commitments are different numbers, and a statement that does not say which one it means has said nothing.

What does an excuse right do to a call everybody else is paying?

Every capital call in this fund is issued to all investors in proportion to what they committed, so each of them pays the same percentage of its own commitment on each call. An excuse rightA right to be left out of a particular investment, agreed in advance. is the one contracted thing in Nilgiri Growth Partners Fund II that can break that identical percentage. Letter 2 gives investor 3, an overseas investor at Rs 80,00,00,000, the right to be excused from any investment in a sector its own mandate excludes.

An excuse right is not a discount in disguise, and the reason it exists is worth pausing on. Some investors are forbidden by their own governing rules from being exposed to certain activities, and the prohibition is theirs, not the fund's. Think of a temple trust that has taken a vow about what its money may touch, or a bank treasury whose own board has ruled out a particular sector. Such an investor either gets a contracted way to sit out those investments or it cannot join the fund at all.

Here is what happens on a call when the right is used. The numbers below are a counterfactual built on this fund's commitments, not one of its actual seventeen drawdowns.

Read the two totals first: both are Rs 21,00,00,000. The fund does not raise less because somebody sat out; it raises the same amount from a smaller base. With investor 3's Rs 80,00,00,000 taken out, the base drops from Rs 5,00,00,00,000 to Rs 4,20,00,00,000, and Rs 21,00,00,000 over Rs 4,20,00,00,000 is 5.0 per cent rather than 4.2 per cent. Investor 1 pays Rs 5,00,00,000 instead of Rs 4,20,00,000 on that call, an extra Rs 80,00,000, and investor 12 pays Rs 25,00,000 instead of Rs 21,00,000, an extra Rs 4,00,000. Add up the extras across every remaining party and they come to exactly the Rs 3,36,00,000 investor 3 did not pay.

So it does change something for everybody else, and here is the honest accounting of what. The remaining investors put in more money on that call. Their percentage of that investment is larger too, so they also receive more of whatever it produces. Nobody has been charged for somebody else's benefit. Exposure has changed and entitlement has not, and that is the whole reason an excuse right sits in the pile that does not move economics.

One fact from the record settles the question. In Nilgiri Growth Partners Fund II every one of the seventeen calls to the record date at the end of Year 9 Quarter 2 went to all investors in proportion, and every one of the twelve stands at exactly 96.0 per cent of its commitment paid in. The arithmetic only holds if nobody was ever excused from anything. Investor 3's right exists in letter 2 and has not been exercised once.

Which rights cost the fund nothing at all to grant?

Three of the six, and the pattern behind them is worth naming because it is what makes the practice workable. Letter 2's extra reporting on investor 3's own timetable and letter 5's notification to investor 8 if the manager's team composition changes are both requests for information the fund already has. The fund is not creating value for one investor and taking it from another; it is sending an email earlier or in a different shape. Letter 5 in particular sits alongside the fund's key-person provision rather than replacing it, so investor 8 is told about a change and the automatic consequences of a key person leaving are unaffected. The key-person provision is covered separately.

Letter 3 does two things and both are free. The confirmation on regulatory capital reporting is a statement about facts that already exist, given so that investor 4's own supervisor can be satisfied about how the position is classified. The transfer rightA right to move the interest to another entity on stated conditions. lets investor 4 move its interest to any entity under the same control. The name on the fund's register changes and the division of the fund's money does not. Rs 60,00,00,000 of commitment sits with investor 4 before the transfer and Rs 60,00,00,000 sits with its sister entity after it.

Letter 4's co-investment rightA right to be offered a chance to invest alongside the fund in a holding. of first look is subtler and it is worth being precise. A co-investment is money investor 5 puts into a company directly, outside the fund, alongside the fund's own cheque. The fund's arithmetic never sees it, so the other eleven investors' share of everything the fund holds is untouched to the last rupee. Where a co-investment right does raise a question, it is about how opportunities get allocated between the fund and the people invited to sit beside it, and that question is covered under conflicts rather than here.

The one letter that touches economics: who actually paid for it?

Letter 6 goes to investor 12, the co-investment vehicle for the manager's own senior staff. Investor 12 committed Rs 5,00,00,000, being 1.0 per cent of the fund's Rs 5,00,00,00,000 and 1.0 per cent of the Rs 4,90,00,00,000 the twelve investors committed, and it pays no management fee and no carried interest. A waived fee is unambiguously a change to somebody's economics, so letter 6 goes in the first pile, and the only question left is out of whose pocket.

Work the amount first. The fund's management fee runs at 2.00 per cent a year on aggregate investor commitments during the five-year investment period. Investor 12's Rs 5,00,00,000 at 2.00 per cent is Rs 10,00,000 a year, and across the five years of the investment period that is Rs 50,00,000. The manager bore every rupee of it out of its own fee, rather than the fund granting a rebateA reduction paid out of the fund rather than out of the manager.. The consequence is exact and it is checkable: the fund's fee base stayed the full Rs 4,90,00,00,000, the fund kept charging Rs 9,80,00,000 a year through the investment period, and the manager's own income from that fee fell to Rs 9,70,00,000 a year.

The third row is the check that settles it. Investor 1 committed Rs 1,00,00,00,000 and the fee is 2.00 per cent of aggregate investor commitments, so investor 1's own share of the annual charge is Rs 2,00,00,000 whether letter 6 exists or not. The same logic across the twelve gives individual shares that sum to Rs 9,80,00,000, the fund's whole annual charge. Nothing in letter 6 disturbs a single line of it. Letter 6 has a second half, the waiver of carried interest, and Nilgiri Growth Partners Fund II has paid no carried interest at all to the record date, so that half has cost the manager nothing so far. How carried interest is calculated, and the order money comes back in, are covered separately.

Out of the fund or out of the manager: why does that question beat the size?

Because the two answers land on completely different people, and the concession looks identical either way. Set letter 6's Rs 10,00,000 a year beside a counterfactual in which the fund itself paid investor 12 back the same Rs 10,00,000, and watch what changes.

Read the right-hand panel slowly. A rebate paid by the fund is a cost of the fund, and a cost of the fund is shared by everybody in it in proportion to what they committed. Investor 1, at 20.0 per cent of the fund's Rs 5,00,00,00,000, would carry Rs 2,00,000 a year of it. Investor 12 would carry its own 1.0 per cent, being Rs 10,000, so its Rs 10,00,000 rebate would be worth Rs 9,90,000 net to it rather than the full amount. Everybody other than investor 12 would carry Rs 9,90,000 a year between them, and Rs 9,90,000 plus Rs 10,000 is the Rs 10,00,000 the calculation started from. The rupees do not disappear under either wording; they simply come from a different pocket, and only the document says which.

What would a 25 basis point discount have done instead?

Letter 1 grants no such thing, so what follows is a counterfactual. Suppose letter 1 had instead cut investor 1's management fee by 25 basis pointsOne hundredth of one per cent, so 25 basis points is 0.25 per cent., from 2.00 per cent to 1.75 per cent on its Rs 1,00,00,00,000 of commitment. The cut is Rs 25,00,000 a year, and Rs 1,25,00,000 across the five years of the investment period.

Checking it from the other direction is the habit worth building. The other eleven investors committed Rs 3,90,00,00,000 between them, and at 2.00 per cent that is Rs 7,80,00,000. Investor 1 at 1.75 per cent on Rs 1,00,00,00,000 is Rs 1,75,00,000. Together they come to Rs 9,55,00,000, exactly Rs 9,80,00,000 less the Rs 25,00,000. The discount is 2.6 per cent of the fund's Rs 9,80,00,000 annual charge, not a large number, and the small size is rather the point. A concession small enough to look harmless is exactly the one nobody checks the payer on.

Now split it the same way as before. Borne by the manager, its income falls to Rs 9,55,00,000 a year and no other investor is touched. Rebated by the fund, the manager keeps its Rs 9,80,00,000, the fund is Rs 25,00,000 a year lighter, and every investor carries a share by commitment: investor 1 carries its own 20.0 per cent, being Rs 5,00,000, so it is Rs 20,00,000 a year better off rather than Rs 25,00,000, and the rest of the fund carries that Rs 20,00,000. Same 25 basis points. Same rupees. Two entirely different sets of people paying.

If investor 1 holds a letter, why is its multiple the fund's own 1.50 times?

Because letter 1 grants a committee seat and a right to elect, and neither of those is a rupee. Investor 1's own numbers are the cleanest proof that the sorting into two piles is not a debating point. Investor 1 holds the largest commitment in the fund and one of only six letters. Every line of its position is simply 20.0 per cent of the fund's line, so its outcome at the record date at the end of Fund II Year 9 Quarter 2 is the fund's own outcome, line for line.

The two checks run as follows. Rs 87,60,00,000 of distributions plus Rs 56,40,00,000 of residual value is Rs 1,44,00,00,000 of total value, and Rs 1,44,00,00,000 divided by the Rs 96,00,00,000 investor 1 has actually paid in is 1.50 times. Naming the denominator matters. The figure here is total value measured against money paid in, and the same fund produces different figures against acquisition cost and against commitment. Reporting covers those two separately. Investor 1's 1.50 times is identical to the fund's 1.50 times, and that identity is what it looks like when a side letter has not touched economics.

The last row carries a trap worth naming. Investor 1's unfunded commitment is Rs 1,00,00,00,000 less Rs 96,00,00,000, or Rs 4,00,00,000. The figure is not the Rs 20,00,00,000 in the right-hand column; that is the whole fund's unfunded commitment, being 4.0 per cent of Rs 5,00,00,00,000, and investor 1's 20.0 per cent share of it is the Rs 4,00,00,000 already derived. Two numbers, one of them five times the other, and the only defence is doing the subtraction on the investor's own line.

How does an investor find out what other investors were given?

Through whatever its own documents give it, and through nothing else. The answer is flat and slightly uncomfortable, so sit with it. A side letter is an agreement between the fund and one investor. An investor who holds no most-favoured-nation right and no disclosure undertaking has no contractual route to the contents of anybody else's letter, and may never learn that one exists.

A most-favoured-nation right without a disclosure obligation attached to it is therefore worth very little: a right to elect into a term that is never disclosed is not a right that can be used. Look back at the five-step ladder. Step 2, the disclosure, is the one that carries the whole mechanism, and a right whose holder has to guess what to ask for has already failed at step 2. In practice the disclosure and the right travel together in the same letter, and the period inside which the holder must elect starts from the disclosure rather than from the grant.

There is a second route, and it is a governance one rather than a contractual one. Investor 1's letter also grants a seat on the investor advisory committee, and a committee seat puts a person in the room where the manager reports. The investor advisory committee and what it consents to are covered separately. The disclosure a fund owes about its arrangements, to whom and when, is set by the Securities and Exchange Board of India at sebi.gov.in for a vehicle registered there, and it changes.