Bain reins in side letters; will others follow?

Bain Capital did something that caught the attention of limited partners this year.

With its third Asia fund, which closed in December on $3 billion, the firm limited side letters. This was something Bain had done in past Asia funds, so it wasn’t new for the firm. But Bain appears to be unique in trying to simplify what several sources described as a burdensome process.

“Side letters have gotten out of control from an execution [and] practicality standpoint,” said a consultant who works with LPs.

“The whole ecosystem needs to figure out the side-letter thing,” said an LP from a university endowment. “It is a hassle and costly for the GPs.”

Bain was able to push back on side letters in part because it received heavy demand for its third Asia fund, which closed on its hard cap. Some sources believe other strong GPs may pursue a similar path — a trend that would help simplify a drawn-out process, but could also leave LPs without one of their major negotiating tools.

“The side letter, if used appropriately, is an effective tool for the GP to satisfy LP concerns that are specific to that investor, without having to go through an [LPA] amendment process,” said Andrew Ahern, a partner at law firm Debevoise & Plimpton who works in fund formation. “They serve as a utility in the negotiating process, a way to allow a GP to say ‘yes’ to investors.”

How it works

About half (46.7 percent) of North American GPs said they sign-side letter agreements with LPs granting them more favorable terms than other LPs in the fund, according to the 2016/2017 “PE/VC Partnership Agreements Study,” which is produced by Buyouts Insider, publisher of Buyouts.

Some side-letter terms are imperative to an LP’s ability to commit to a fund. Many European investors, for example, avoid exposure to weapons manufacturers, so they may carve out an exception in a side letter. Likewise, a Saudi Arabian investor who can’t have exposure to alcohol-related investments might ask for an opt-out provision in a side letter.

But some side letters contain “wish list” items for LPs — things that would not prevent an LP from committing to a fund if a GP rejects them. These items may include getting a first look at co-investments in a specific industry, granting a certain LP a longer period of time to fund capital calls, certain liability provisions, or notification agreements, sources said.

Many LPs, especially big, established groups, have “form letters” laying out their side letter requests that include 30 or more requested terms.

Side letter requests keep getting longer, sources said. “In the 10 years I’ve been practicing, it feels like the number of side-letter provisions has doubled,” said Ahern of Debevoise & Plimpton.

Another fund formation lawyer said: “Sometimes you hear sponsors say: ‘We really need to get this [side letter process] under control.’ But when it comes to getting that next investor in, it becomes: ‘Oh, we’ll start doing this next time.’”

Most favored nation

What draws out the side-letter process is the “most favored nation” review. These clauses allow every LP to review side-letter terms for every other LP in a fund. During that process, LPs can “elect” to pick up terms offered to other LPs.

The review involves looking at every side letter in the fund, which can involve lawyers reviewing hundreds of pages.

“When we get the MFN [most favored nation] election package it is time-consuming and expensive for us to have lawyers review 100 side letters in detail to see which provisions we should elect,” the endowment LP said.

The most favored nation review is not consistent across the industry. Some GPs don’t offer MFN reviews. Some will offer MFN based on size of commitment: For example, if you commit $5 million, you can review side letters from other LPs who committed $5 million or less. Still other GPs offer MFN reviews across the board, Ahern said.

According to the Buyouts Insider study, 41.7 percent of North American GPs offered most favored nation clauses to some LPs, 20.8 percent offered them to all LPs, and 37.5 percent didn’t offer them at all.

“It used to be that LPs got ‘special,’ valuable terms in side letters, but everyone learned to require MFN provisions so impact was diminished,” said an LP at a large public system. “It’s hard to manage an agreement with lots of different side letters, each with quirks, especially for GPs like Bain with lots of LPs.”

Simplifying the process

In Bain’s case, LPs could include side letters for absolutely necessary legal and regulatory provisions. However, Bain worked to limit any other special terms in side letters, three people with knowledge of the fund said. It is not clear exactly what terms were off limits.

Charlyn Lusk, a spokeswoman for Bain, declined to comment.

Bain’s move has the potential to spark a trend among other GPs who see heavy demand for their funds, sources said.

The overall goal is to simplify the process. There are other ways to do it, sources said.

One way, which is used by a large firm, is for the GP to provide a standard set of provisions that will go into side letters from which LPs can choose, said the fund formation lawyer.

Another way is to save the MFN review until the fund has held a final close, rather than sending individual side letters to each investor every time a new LP makes a commitment, the attorney said. “If you do it at the end, people can go over it all at once,” the attorney said. GPs help this process along by consolidating individual side letters into a compendium.

Some GPs try to convince LPs asking for similar provisions to agree to the same language, sources said. The idea is: “We agreed to do something substantially the same with another investor, so we’d like to use the same language,” Ahern said. This helps limit the review. The alternative would be numerous side letters all asking for the same provision but each worded slightly differently.

For there to be any real change with side letters, GPs must stick to their decision to limit them, even in the face of a big LP coming in with a big commitment.

“If I’m an investor in a fund and … I don’t ask for a side letter and I get in the mail a compendium that looks just as long as other funds because the GP caved to a couple 800-pound gorillas, then I’m annoyed,” Ahern said.

LPs can also do their part, most significantly by only asking for terms they must have rather than wish-list items.

“It should be about the things you care about and that are important to you,” Ahern said.

It will be tough to change how it works, though, without “collective action” on the part of the LP community. And as anyone who has tried to organize LP action knows, that’s no easy task.

Photo: Zeke Thurston of Big Valley, Alberta, rides the horse Easy To Love to win the Saddle Bronc event during Championship at the finals of the Calgary Stampede rodeo in Calgary, Alberta, July 12, 2015. REUTERS/Todd Korol