Happy Thursday!

Side letters are really common in this business and while they sound impressive, an LP should (rightfully) wonder whether they’re good or bad for their own investment.

After defining what side letters are, today I’ll break this down from two angles:

• Is a side letter good for you if you’re the one getting it?

• Is a side letter good for you if you are NOT the one getting it?

First - what is a side letter?

In a real estate syndication (can be single asset/portfolio acquisition or a fund), a side letter is a separate agreement between the GP and a specific LP that modifies certain terms of the main operating agreement or subscription docs.

Common side letter provisions would be:

• Reduced management fees

• Enhanced reporting

• Improved waterfall (a better split and/or pref to the LP getting the side letter)

• MFN - most favored nation rights

• Co-invest rights

• Advisory board seats

• Capacity guarantees in future funds

• Special liquidity/transfer rights

• Control rights, although this is far more common on JVs, where the “side letter” is going to a person or institutional that’s bringing a massive chunk (typically 80%+) of the LP capital

While side letters are most common with very large transactions or funds, I’ve seen them come up more and more in sub $25mm syndicated deals - especially with large check writers.

With the definition out of the way, the next question is - are they actually good for you?

If you’re the one getting the side letter

On the surface this seems like a weird question - obviously it’s a good thing, right? You’re getting something everyone else is not. While that’s true, I think there’s more to the story.

The Pros

1. Better Economics

The most obvious benefit is a lower management fee or a better promote split.

Example:

• Standard terms: 2% management fee, 20% promote

• Your side letter: 1.5% fee, 17.5% promote (meaning to say that you get to keep more of the upside)

On a $1M investment over a 5-year hold, that can mean tens of thousands of dollars in incremental return… so a clear pro on the upside.

2. More Information

Some side letters provide enhanced reporting - quarterly calls, property-level detail, bank statements, etc.

If you are running a family office or deploying serious capital, this can materially improve your ability to underwrite and monitor risk during the lifecycle of the deal.

3. Control Rights

While this is more common in JVs or cases where the LP puts up the majority of the equity in deal (80%+ most likely), this gives you quite a bit of leverage in things aren’t going according to plan.

The Con - focusing too much on the upside

While this isn’t the case with institutional LPs, some family office investors look at side letters as a way to de-risk a deal and their investment amount. This has an element of truth (reporting helps, and so do control rights as we discussed above), but I think the downside is still fairly strongly tied to manager selection and the business plan.

In other words, it’s true that you have more information than other LPs and you might even have the ability to force a sale … the only problem is that once you’re at the point of questioning the reporting or forcing a sale things are likely not going according to plan.

So in summary, don’t conflate downside risk/analysis with getting a side letter - the side letter helps on the upside, but it’ll only help you mitigate some of the downside.

If you’re not the one getting the side letter

This one’s particularly important to retail LPs - you’re writing a $250k check in a deal and you find out there’s someone who’s getting a side letter (or there’s a JV partner perhaps). Good for you as that individual LP … or is it actually bad?

The “good for you” case

1. Oversight

As we spoke about above, side letters often include:

• Enhanced reporting requirements

• Advisory board structures

• Key person provisions

Even if those rights apply only to the anchor LP, they can raise the bar for the entire investment due to the additional oversight (or shall I say pressure?). It’ll force things to be on time, and be more professional since the GP is obligated to report to this anchor (and there are consequences for not doing a good job).

Sometimes smaller LPs benefit from this improved discipline indirectly - you might be on the couch, but the institution with a $10mm check in the deal is watching things like a hawk (and typically knows when things aren’t going in the right direction).

2. Diligence

While you shouldn’t send a wire based on someone else’s investment and/or due diligence it’s certainly an extra benefit to you that someone that’s writing a large check is looking at this alongside you with more at stake.

Before we get too excited, let’s look at the primary counter to this argument:

• $10mm is a large check to you, but if it’s being deployed by this other LP out of a $1b fund it’s a rounding error to the LP - so just because they have a big check out doesn’t mean they’ll be hurt as much as you would be if things don’t go the right way. This means that you and this other partner won’t have the same risk tolerance!

The “bad for you” case - misalignment

You’re going into the deal already knowing that the anchor investor will get better economics and reporting standards most likely … but your economics still look fine, so what’s the big deal?

The biggest risk here is misalignment between your incentives (optimizing return for yourself) and the incentives of this anchor/JV investor, to the extent that they have significant say in the deal (aka control rights).

What happens if the deal is going alright, but for whatever internal reason that JV partner needs liquidity and forces a sale? This isn’t the worst thing in the world for you since you likely got something back on the deal, but the outcome could’ve been much greater and both you and the GP won’t be happy.

On a downside scenario, there’s also a similar risk of the anchor/JV investor pulling the plug while the GP might’ve been more committed to seeing the deal through to save their own reputation (and your LP dollars).

Have a wonderful rest of the week, I hope this was helpful!

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