Many capital pools, including private equity funds, hedge funds, venture capital funds, and others, structure themselves as  limited partnerships.  They are generally governed by a limited partnership agreement (an “LPA“).  Often, and especially in private equity funds and venture capital funds,  ”side letters” between individual limited partners and the general partner modify the standard relationship between the limited partners and general partner.  Side letters can range in scope from administrative matters to providing substantive rights to limited partners.  Obvious questions include: what can parties include in a side letter what what ought to be included in the LPA?

There are three basic categories of issues: (i) how the LPA treats the issuance of side letters, (ii) what provisions are appropriate to include in a side letter regardless of the express terms of the LPA, and (iii) disclosure of the side letter to limited partners.

Treatment of Side Letters under the LPA

In general, LPAs may (i) be silent on the ability of the general partner to issue side letters, (ii)  contain blanket provision that permits side letters to be issued, or (iii) contain an express provision that permits side letters to be issued but also governs certain aspects of side letters, including, among other things, the extent to which a side letter may be inconsistent with the terms of the LPA and whether other limited partners are entitled to the benefits of any particular side letter that may be issued from time to time.

Appropriate Provisions to Include in Side Letters

At the time of writing this post, the regime is quite flexible.  But, one should still be cautious as it isn’t “anything goes”.

A general partner in Canada generally owes fiduciary duties to limited partners. Such duty would typically include an obligation for fair dealing with limited partners. To the extent that there is a side letter in favour of one or more limited partners, one could argue that the general partner discriminates amongst limited partners.  It is suggested that appropriate disclosure, and preferably specifically addressing side letters in an LPA, would significantly reduce any risks of any allegations by limited partners against the general partner that it breached its fiduciary duty in connection with the issuance of any side letter, subject to the following with respect to inconsistency between side letters and the terms of the LPA.

The relationship between the general partner and limited partners is generally governed by the LPA, which is a multilateral agreement between all partners. To the extent there is a bilateral agreement between the general partner and one or more particular limited partners which is inconsistent with the terms of the LPA, there is a question as to how any level of inconsistency would be interpreted by a Canadian court.  Not surprisingly, it is likely that any decision would be highly fact specific. However, it is suggested that there are levels of inconsistency which are more likely to be tolerable than others.

At one end of the spectrum, side letter requirements which do not affect other limited partners (other than in an immaterial manner), such as extra reporting requirements, are not likely to raise judicial concerns regardless of whether the LPA expressly addresses inconsistency between an LPA and side letters.  At the other end of the spectrum, side letter provisions which clearly and materially affect other limited partners should be carefully considered, even if the LPA provides express permission for inconsistency between the LPA and side letters. For example, an LPA  for an infrastructure fund may state that it is intended to invest broadly in North American infrastructure across various sectors. If the general partner of such infrastructure fund proceeded to issue a side letter requiring that the fund only invest in one narrow infrastructure sector in one country, such side letter would significantly alter the overall nature and character of the fund. In such circumstances, one could envision a Canadian court viewing such a provision differently than a provision that simply provides for extra reporting requirements. Numerous other types of terms lie in between the two ends of the spectrum, and it is suggested that each term proposed for inclusion in a side letter be considered in light of this spectrum.

Further considerations also arise in connection with how side letters are disclosed to limited partners, if at all (especially where side letter provisions may affect other limited partners) as well as broader considerations on the types of disclosure that may be made to limited partners, as further discussed in part below. General partners also need to weigh the effect of subsequent side letters on existing limited partners, especially if a subsequent side letter materially alters the nature of the fund, and therefore materially alters the basis on which the previous limited partners invested in the fund.  Such an analysis may take into account, among other things, the passage of time as between the  investment by the previous limited partners and those who are obtaining the benefit of such a side letter.

Disclosure

LPAs that permit side letters may regulate the “how and when” side letters are to be disclosed to other limited partners.  One may consider disclosing matters in side letters that may materially affect other limited partners:

• enhanced control rights
• preferential liquidity/redemption rights;
• the availability of preferential fees; and,
• terms that materially alter the investment program disclosed in the fund’s offering documents.

Conclusion

As in much of commercial and securities law, much of this comes down to a general partner treating all limited partners fairly.  Capital pools formed as limited partnerships should be transparent and have clear governance structures.  Discriminatory and preferential treatment should be agreed to be everyone and such treatment should be fully disclosed.