Key Side Letter Terms for Institutional Investors: What You Need to Know
For institutional investors in private equity, side letters are essential tools to tailor the terms of their investments to meet specific legal, regulatory, tax, and strategic requirements. The Limited Partnership Agreement (LPA) provides the general framework, but side letters allow investors to negotiate provisions that better align with their particular needs.
In addition to common provisions like Most Favored Nation (MFN) Clauses and Co-Investment Rights, institutional investors often require customized tax-related terms to ensure compliance with complex tax obligations. Here, we’ll discuss some of the key side letter provisions that institutional investors should focus on, including tax provisions.
1. Most Favored Nation Clause
What it is: The MFN clause ensures that an institutional investor receives the best possible terms offered to any other investor of comparable size and commitment. If more favorable terms—such as lower management fees—are offered to others, the MFN clause allows the investor to claim those same terms.
Why it matters: This provision ensures that institutional investors are not at a disadvantage compared to other LPs, particularly in terms of fee structure, reporting rights, and co-investment opportunities. It’s particularly useful for large investors who want to safeguard their interests across multiple terms.
Considerations: MFN clauses can vary in scope. While some may include economic benefits, others might exclude certain privileges like co-investment rights. Investors should ensure the MFN clause covers a broad range of terms, including tax-related provisions.
2. FATCA and Tax Reporting Compliance
What it is: The Foreign Account Tax Compliance Act (FATCA) requires funds to disclose information about U.S. investors to the IRS. Institutional investors often seek provisions in side letters ensuring that the fund will comply with FATCA reporting obligations and will not expose the investor to penalties due to non-compliance by other LPs.
Why it matters: For institutional investors, particularly those with U.S. tax obligations or U.S. investors in their own structure, FATCA compliance is crucial to avoid penalties. A side letter provision ensures the fund takes responsibility for necessary reporting and documentation.
Considerations: Investors should ensure the side letter includes language obligating the fund to use "best efforts" to remain FATCA-compliant. In addition, provisions should specify that the fund will manage any tax withholding and reporting obligations on behalf of the investor.
3. Co-Investment Rights
What it is: Co-investment rights give investors the opportunity to invest alongside the fund in certain deals, often without paying management fees or carried interest. This right is highly coveted by institutional investors seeking to deploy additional capital on favorable terms.
Why it matters: Co-investment can significantly enhance returns, as it allows investors to participate in specific deals without incurring additional fees. It’s a key term for large investors who want increased exposure to attractive portfolio companies.
Considerations: Investors should negotiate for a clear framework that defines their priority in co-investment opportunities. This is especially important when co-investment rights are limited.
4. AIV (Alternative Investment Vehicle) Provisions
What it is: AIVs are separate entities that a fund may use to make certain investments for tax structuring purposes. Side letters often include provisions ensuring that the investor’s participation in an AIV does not lead to additional tax liabilities or reporting requirements beyond what was expected when investing in the main fund.
Why it matters: AIVs are typically used to optimize tax structuring for specific investments. However, institutional investors may be concerned about their tax exposure through these vehicles, particularly if they result in unintended tax consequences.
Considerations: The side letter should specify that the fund must notify the investor before including them in an AIV and provide any necessary tax information to help the investor meet its tax reporting obligations. The investor may also negotiate for the right to opt out of participating in an AIV if it leads to tax disadvantages.
5. Excuse and Exclusion Rights
What it is: Excuse rights allow an investor to be excused from participating in certain investments if those investments violate the investor’s legal, regulatory, or policy restrictions. This may include exclusions related to ESG policies or restrictions on investing in certain countries or sectors.
Why it matters: Institutional investors, particularly pension funds and endowments, often have specific legal mandates or internal policies that prohibit them from investing in certain industries, such as tobacco, firearms, or fossil fuels. Excuse rights ensure they can comply with these restrictions.
Considerations: It’s important to clearly define the scope of investments that trigger these exclusion rights, such as geographical regions, industries, or ESG-related concerns. The process for opting out should be efficient and not disruptive to the fund's operations.
6. Controlled Foreign Corporation (CFC) and Passive Foreign Investment Company (PFIC) Provisions
What it is: U.S. institutional investors often require provisions in side letters that address CFC and PFIC rules. These provisions ensure that the fund will avoid investments that would cause the investor to be subject to the burdensome U.S. tax rules associated with CFCs or PFICs.
Why it matters: U.S. investors are subject to complex tax reporting obligations and potentially unfavorable tax treatment if they invest in entities classified as CFCs or PFICs. Side letter provisions can prevent unintended tax consequences by ensuring the fund manages its investments to minimize CFC or PFIC exposure.
Considerations: Institutional investors should ensure the side letter obligates the fund to notify them if any portfolio company is classified as a CFC or PFIC and to provide the necessary information to comply with U.S. tax reporting requirements. The provision should also address what happens if an investment inadvertently becomes a CFC or PFIC.
7. Key Person Provision
What it is: This provision ensures that certain named individuals at the general partner or fund management team remain actively involved in the fund’s management. If any of these key persons leave, the investor may have the right to suspend or terminate their capital commitments.
Why it matters: Many institutional investors commit to funds based on the expertise and track record of specific individuals. The departure of these key persons poses significant risk to the success of the investment.
Considerations: Investors should carefully negotiate who qualifies as a "key person" and what level of involvement is required to meet the provision. It’s also important to establish clear consequences if the key person leaves, such as suspension of capital commitments or withdrawal rights.
8. Tax Efficient Structuring
What it is: Institutional investors often negotiate for provisions that require the fund to pursue tax-efficient investment structures. This can include obligations to minimize withholding taxes, optimize for capital gains tax treatment, and ensure that investments don’t expose investors to unnecessary tax burdens.
Why it matters: Tax structuring can significantly affect the after-tax returns of institutional investors. Ensuring that the fund is structured to optimize tax treatment—whether through AIVs, holding companies, or other vehicles—can enhance net returns for investors.
Considerations: The side letter should specify that the general partner will use “commercially reasonable efforts” to structure investments in a tax-efficient manner, and that the fund will work to minimize withholding taxes and other tax liabilities for its investors.
9. FATCA and CRS Reporting Compliance
What it is: FATCA and Common Reporting Standard (CRS) impose obligations on funds to report information about certain investors to tax authorities. Institutional investors may require provisions in side letters ensuring that the fund complies with these obligations without creating additional burdens for the investor.
Why it matters: Non-compliance with FATCA or CRS can result in significant penalties for both the fund and its investors. Institutional investors need assurances that the fund is managing its compliance effectively to avoid penalties.
Considerations: Investors should ensure that the side letter requires the fund to comply with FATCA and CRS reporting requirements and to provide any necessary tax documentation promptly. Additionally, investors may request indemnification if the fund’s failure to comply results in penalties.
Conclusion
For institutional investors, negotiating side letters is a critical step in ensuring their unique needs are met, particularly regarding tax efficiency and regulatory compliance. Provisions addressing FATCA, CFCs, AIVs, and other tax-related issues can help protect investors from unintended tax consequences and ensure they are compliant with their obligations.
At Lazarus PC, we specialize in negotiating side letters that protect institutional investors’ interests and ensure compliance with complex tax and regulatory frameworks. Contact us today to learn more about how we can assist with your private equity investments and side letter negotiations.