Tag Archives: Due Diligence

The Head and Tail of Side Letters in Alternative Investment Funds

This article was first published by IAAFI – Indian Association of Alternative Investment Funds

A side letter is a document or a letter that is ancillary to another existing contract. In investment world, Side letter would mean something over and above your general terms and conditions that are binding under the investment product agreement i.e. PMS or AIF or any other investment vehicle.

Executing side letters with contributors has become an increasing phenomenon in the Alternative Investment Fund (AIF) documentation space. While the genesis of the practice seems to have stemmed from the need to have supplementary, clarificatory terms and sometimes preferential rights to large or strategic investors in a fund, the modality is now being used at a much higher frequency. The general dicta of avoiding side letters, however, prevail for various reasons of maintaining fairness, integrity and transparency, concerns around legality and enforceability. In this article we have explored the enforceability and regulatory nuances around the usage of side letters.

Enforceability of Side Letters in General.

  • From a contractual perspective, side letters could be said to be enforceable if they fulfil the basic tenets of a valid and binding contract under the Indian Contract Act, 1872, i.e. offer and acceptance, made by the free consent of the parties, for a lawful consideration with a lawful object, and not expressly declared to be void[1].
  • Enforceability could also flow from equity and relief under Chapter II of the Specific Relief Act, 1963. However, in a fund context that is structured as a trust, Section 11 of the Specific Relief Act, 1963 also comes into play that specifies that a contract made by a trustee in excess of his powers or in breach of trust cannot be specifically enforced. [Note: Enabling provisions in the indenture of trust need to be drafted carefully, as such.]
  • The principle of law as stated in Von Hatzfeldt – Wildenburg v. Alexander[2] is that:

“…… if the documents or letters relied on as constituting a contract contemplate the execution of a further contract between the parties, it is a question of construction whether the execution of the further contact is a condition or term of the bargain or whether it is a mere expression of the desire of the parties as to the manner in which the transaction already agreed to will in fact go through…… In the latter case there is a binding contract ……”

In the private equity/venture capital investment space, we often see side letters being sought for by seed stage or early stage institutional investors for grant of preferential or superior rights that provide better protection against future dilution of their existing voting or other rights in investee companies.

However, from an AIF documentation perspective, let us now look into the regulatory regime under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 (“AIF Regulations”).

Side Letters in AIFs – SEBI Perspective.

Chapter III and Chapter IV of the AIF Regulations talk about investment conditions and restrictions and general obligations and responsibilities of a sponsor or an investment manager, respectively. The relevant provisions put a lot of focus on adherence to placement memorandum terms, material changes only through consent of two-thirds of unitholders by value, the sponsor and manager acting in fiduciary capacity towards all investors. Through its Circular No. CIR/IMD/DF/7/2015 dated 1 October 2015 (“Circular”), the Securities and Exchange Board of India (SEBI), has further stressed upon the duty of all managers to carry out all the activities of the AIF in accordance with the placement memorandum circulated to all unit holders; and also, to act in the interest of unitholders and not take any action which is prejudicial to the interest of the unitholders. However, in the same Circular, AIF, manager, trustee and sponsor have also been mandated to exercise due diligence and independent professional judgment for the conduct of the business.

Therefore, the question that arises here is whether offering a preferential or special right to an investor through a side letter, affects the fiduciary responsibility of the sponsor or the manager towards the other investors. There seems to be 2 schools of thought here. One stressing upon the highest level of transparency and adherence to principles of avoidance of conflict of interest. The other thought, however, comes from the practical perspective of having to raise funds by the investment managers. Providing certain special rights which of course do not materially change the commercials terms of the applicable class of units, investment strategy, investment purpose and investment methodology of a fund, could sometimes be crucial for sealing the deal with a large or strategic investor. Side letters are also useful for providing contractual clarifications to even investors who want to join in late. The most frequent requests from the investors in this regard vary from limitations on time horizon and capping of indemnity and contributor giveback amounts to waiver of certain charges or fees, etc.

A constructive (or aggressive) interpretation of the AIF Regulations and the Circular could lead to the understanding that fund managers may exercise prudence and independent professional judgment for entering (if willing to take risk) into side letters, however, acting throughout in the interest of all unitholders and maintain highest standards of integrity and fairness and under an enabling provision captured in this respect in the placement memorandum.

One should remember that investment manager, holding a fiduciary role, merely has delegated powers from the trustee on the back of investment management agreement and typically can’t enter into contracts on the side-lines with investors without consent of the trustee or overriding/relaxing the main contract which the trustee has with investors. This could be construed as breach of trust and fiduciary duty depending on case circumstances and investment manager would need to indemnify the investors for any potential loss. Large number of side letters would also add to the administrative and legal burden on the fund/investment manager.

From an investor’s perspective, one should be careful on the enforceability, permissibility and workability of such letters and if they add any substantial value to the overall value proposition on manager selection vs. product selection.

From a Wealth Manager or Investment Advisor perspective, presence of side letters in their approved products might be construed as a red flag in due diligence process as limiting the transparency and fairness in treatment for their own investors.

Some much needed clarity from the Securities and Exchange Board of India (SEBI) on these lines could provide some color on the practice, one way or the other, and help in reduction of security and risk concerns amongst the investor base.

[1] Section 10 of the Indian Contract Act, 1872

[2] As quoted by the Hon’ble Supreme Court in Kollipara Sriramulu v. T. Ashwathanarayana & Ors. – 1968 SCR (3) 387

Authors: Ms. Sohini Mandal, Associate Partner, NovoJuris Legal and Mr. Biharilal Deora, Director, Abakkus Asset Manager LLP



Today’s competitive forces have brought a paradigm shift in the mindsets of the investor community, that focuses more on business ground rules than ever before. Profitability is not the only parameter which plays a role. Preferably, the product/business must also exhibit a trend of sustainable development in revenues along with good corporate governance.

To ensure good corporate governance, what is required is an intensive and thorough Due Diligence (“DD”). In the private equity scenario, it can make or break a deal. More often than not, this being a condition precedent, it is an onus on the entrepreneur to support the DD process. The DD process essentially intends to ensure compliance to all applicable laws, identify gaps, ascertain risks and take a final decision.

DD Vs Audit:

Now, the DD process is somewhat different from an Audit process. Audit aims at bringing to the fore; a true and fair picture of the current status, however, DD aims at negative assurances i.e. identifying risks, if any. Moreover, the Audit process is generally defined and scoped out on the basis of the ‘laws of the land’, but DD is somewhat more scoped out to ‘deal-specific and limited issues’.

The Process:

DD usually starts at the inception of a deal. It has become a legal yardstick which enables prospective investors to enter into a transaction.

Recently there have been many instances where concerns were raised, both privately and publicly, about the intensity; quality and timelines of due diligence carried out by professionals around the world. Especially in India, which has witnessed major corporate scams over the last decade or so, it is critical to deploy a structured methodology for carrying out effective Due Diligence.

Due diligence usually involves looking into the various aspects/divisions of a company, subject to the ticket size of the investment. Depending on the industry, a high net worth deal would probably involve an intensive DD process covering all aspects – Legal, Financial, Secretarial, IT, HR and others. The process covers – reviewing documents; seeking more information; identifying gaps and providing a solution to all identified issues. All this is clubbed into one document – commonly referred to as the DD Report.

Takeaway for Entrepreneurs

The investment community is very highly networked and it becomes imperative for the entrepreneur to ensure that he times his pitch accordingly.

The best trick to succeed in this game is to ‘anticipate’. An entrepreneur, who can anticipate Due Diligence, will ensure the compliances are in place even before he starts to pitch the investors.

Technology can play a vital part in ensuring that documentation is in order. Online data rooms like Dropbox, Box and other cloud services are excellent platforms to record and keep – all executed contracts; originals of the licenses procured and other related documents – in one place.

An entrepreneur today, needs to and must think ahead, making sure that his company proactively responds to any Due Diligence that the investor may wish to undertake. This will substantially reduce the turnaround time for closing the deal with his investor. It is critical for the entrepreneur to close the deal, expedite the transaction and get the money in the bank.

Another simple, yet effective tool for an entrepreneur is to be painfully honest and share their concerns (if any), for a long and effective relationship with their investor. Early stage investors definitely like to follow this cardinal principle – ‘the bet is on the jockey and not the horse’, therefore, it is highly recommended that the entrepreneur be open and expressive with the investor.

Experts Required:

Contrary to the general belief, that professionals like lawyers and company secretaries should be hired when the business relays substantial growth, we strongly suggest that they be hired BEFORE any legal contracts and agreements are signed!! Simply put – prevention is better than cure. Most entrepreneurs enter into multiple contracts, agreements and understandings with their employees, customers, clients and shareholders in the initial stages, which usually haunt and hurt their businesses in the future.

The most common and vulnerable areas of concern are –The Founder’s Agreement, Intellectual property protection, promises made to certain employees etc. Hence, it is always advisable to know on what you are riding on and to make sure you have control over it.

Conclusion –

A study conducted by Standard & Poor’s has revealed that in India, there is a direct relationship between corporate governance and market value. The takeaway here being that – investors definitely take DD into account when deciding where to put their money. It also states that “only companies above a certain threshold of governance level, trade at a premium”. Hence, Due Diligence plays an important role in the investment scenario. A ‘clean’ company is a huge attraction to a potential investor.

Disclaimer:  This is not a legal opinion and should not be construed as one.  Please speak with your attorney for any advice.