Fund contracts are becoming more and more complex. At the same time, central risk and responsibility issues are increasingly shifting out of the fund contract. Side letters have become the place where institutional investors try to anchor responsibility where it can no longer be clearly regulated in the contract.
The increasing complexity of fund contracts leads to increasingly difficult handling in practice. Actually, longer LPAs, more detailed regulations and increasingly extensive subscription agreements are supposed to address risks more precisely and clearly assign responsibilities. In practice, however, the opposite of the intended effect is increasingly becoming apparent: a pseudo-professionalization is emerging that suggests controllability without actually producing it.
Fund contracts have not only become longer in recent years, but also denser in terms of content. In addition to sprawling LPAs, even the originally more technical subscription agreements have gained considerably in scope. In addition, there is an increasing overload of legal regulations, the interplay of which cannot always be fully monitored, even with professional legal support. Central questions of interpretation and application can increasingly not be answered unambiguously from the fund contract alone, although this is exactly what it is intended for.
For institutional investors, the question arises as to how they can live up to their responsibility in such complex contracts in such cases. Where doubts remain as to whether risks are clearly understood or clearly assigned in the fund contract, there is a de facto compulsion to actively operationalise responsibility. It is precisely at this point that the function of Side Letters shifts.
In the past, side letters were primarily used to reflect individual investor needs – such as reporting content, formats or frequencies – and to ensure equal economic treatment via MFN clauses. Today, they are increasingly becoming the place where investors set their own set of requirements, because the fund contract no longer always allows this clarity for the parties involved.
This development can even intensify if a (master) fund of funds KVG subscribes as a legal investor: it acts with even greater fiduciary responsibility and, in the dutiful exercise of its function, must also master such issues that have remained open in the fund contract. If, even after comprehensive examination and coordination, essential questions of interpretation or application remain unresolved, it is a consistent measure to actively address them via side letters.
On the other hand, target fund AIFMs often react to this with pushbacks. Responsibility is then occasionally attempted to be limited by means of best-effort or best-knowledge clauses. A negotiation process emerges in which both sides try to make a complexity manageable that can no longer be completely controlled – especially in foreign jurisdictions. As a rule, this translation of complexity back into clear responsibility succeeds. Nevertheless, a residual responsibility may remain that is not clearly assigned.
📌 Conclusion:
- Where contracts only document complexity instead of being sufficiently specific and understandable in terms of content, the truth is that professionalism does not emerge in the industry – but at best its fiction.
- The process of side-letter voting sometimes resembles a creeping diffusion: one side tries to relinquish responsibility, while the other is forced to take it on at least partially.
