1. Introduction
The Alternative Investment Fund (“AIF”) industry has seen tremendous growth in India with more than INR 12 trillion worth of commitments raised as of September 30, 2024, signifying a surge of 30% on year-on-year basis. At present, there are 1466 registered AIFs with multiple schemes operating under them.
A larger part (about 60%) of the total commitments by AIFs was raised domestically, and about 40% was raised from foreign investors. AIFs are becoming a vehicle of choice for high net-worth individuals in addition to institutional investors and it is expected that the industry is likely to surpass INR 100 trillion mark by 2030.
Given the increasing popularity of the investment vehicle, the Securities and Exchange Board of India (“SEBI”) has taken several regulatory measures to revise and update the framework governing AIFs over the past few years. One of these recent measures involves regulation of the differential rights to be given to an investor (“LP”) by an AIF manager.
2. Purpose of Side Letters
Blind-pooled private funds treat investors uniformly, offering them pro-rated rights in the fund. Owing to certain legal, tax, operational, internal, or commercial factors, some investors request for differential rights under ‘side letters’ which clarify, vary, or supplement the provisions of the governing documents of the fund.
Securities market regulators are not too concerned about ‘differential rights’ being offered to certain investors by fund managers, as long as such rights do not become ‘preferential’ to the detriment of other investors, and there is sufficient disclosure.
When the AIF Regulations were introduced, SEBI was unofficially uncomfortable with the idea of side letters. The expectation was not to abrogate rights made available under side letters, but to bring these rights in the main governing documents of the AIF rather than keeping them private. This question often arises from retail investors as well – why should side letters even exist?
The AIF manager is driven to keep these terms in side letters to avoid having to increase its compliances vis-à-vis all investors (which number may even go up to 1000 investors), and keep the benefits limited to those investors who bring in meaningful contributions or add strategic value and good governance measures.
Investors are driven to record their terms inside letters because there is a considerable amount of bespoke information about them and their strategy which form the foundation for these rights, and they do not wish to record such details in the main governing documents.
Large institutional investors view side letters as a critical means for market innovation and good governance. Certain rights which are generally non-negotiable for development finance institutions include draw-stop rights which allow the investors to stop contributing upon occurrence of certain bad acts or causal events, or creation of special panels such as an environmental, social and business integrity (ESBI) panel consisting of only identified development finance institutions. Domestic Indian institutional investors backed by the government also impose penalty provisions such as return of capital requirements along with an interest.
3. Global Regulatory Practices
Side letters typically offer varied commercial and non-commercial terms. Commercial terms include fee breaks, exemption from equalization premium payment, investment allocation limits, restrictions on manager’s and its key persons’ time commitment / subsequent funds while non-commercial terms include most-favored nation (“MFN”) clauses, warranties on compliance with environmental, social and governance principles, committee observer / LP Advisory Committee seats, co-investment offerings, additional reporting, excuse rights and information rights.
Europe’s Alternative Investment Fund Managers Directive (a) requires the disclosure in fund documents of bespoke terms related to which differential rights shall be offered; and (b) obliges the fund manager to ensure that any preferential treatment is disclosed to other investors.
The Private Funds Rules recently debated (though entirely overruled) in the United States between the U.S. Securities and Exchange Commission (“U.S. SEC”) as well as the Institutional Limited Partners Association (“ILPA”), prescribed a higher standard (a) prohibiting preferential treatment (effectively eroding MFN rights); (b) requiring disclosure of fee breaks with actual numbers offered (leaving little room for tailored negotiation); and (c) prohibiting selective / beneficial disclosure of information about portfolio holdings (hitting co-investments / first look rights).
ILPA argued with the SEC that requiring written notice of preferential terms for potential investors would conflict with the MFN process, which typically happens after a closed-end fund's final close. Since side letters are often negotiated up until the final moment, disclosing terms too early would not accurately reflect the agreements of other LPs. It is in the interest of investors to push back on any regulatory restrictions on side letter rights.
The general sentiment among regulators is to ensure transparency and fair treatment of all investors in a private fund. Fair treatment for all investors does not mean identical or equal treatment.
Efforts to treat all investors the same may in fact end up being unfair to some investors, could limit investor choice or investment opportunities and could cause some investors to not be able to comply with their own internal policy, legal or regulatory obligations which are at least in part satisfied through negotiated contractual arrangements with managers.
