LP side letters in the DIFC and ADGM
By Abdullah Mutawi, Partner and Fawaz Elmalki, Senior Counsel
Side letters are common practice when it comes to fundraising by fund managers. Given a few interesting international developments, now more than ever it is critical that DIFC and ADGM fund managers understand the legal implications and the limitations on entering into side letters.
Background
Negotiating side letters is a major part of the private equity and hedge fund fundraising process anywhere in the world and it's no different for Dubai International Financial Centre (DIFC) and Abu Dhabi Global Market (ADGM) fund managers. However, fund managers must be careful not to alter a multilateral investor agreement in favour of one investor in a side letter, as this could turn out to be a perilous exercise.
The capital-raising environment globally has become more challenging, and this has accentuated the appeal of GCC sovereign wealth funds (SWFs) and other deep-pocket investors including government and pension funds, family offices and conglomerates.
The relative abundance of capital within the SWF constituencies means that negotiating leverage is on their side and we expect that the frequency of side letter requests from SWFs, strategic and other institutional investors will only increase in the short to medium term. This may create a dilemma for fund managers and their lawyers who must draft side letters for these types of investors in compliance with applicable funds legislation and the United Arab Emirates regulators who are at the forefront of adopting global best practices.
A side letter is a contract between the fund or the manager/GP and the investor, which sits alongside the multilateral investor agreement (such as the limited partnership agreement, LLC agreement or articles of association) and the investor's subscription agreement. As such, it supplements those other agreements. However, a contract cannot be varied or amended without the consent of all the parties to it unless the contract itself so provides.
Side letter provisions that amend a provision in the multilateral investor agreement that is fundamental to the fund, cause legal challenges when such a side letter favours a single investor. Granting supplemental rights to an investor in a side letter may not adversely affect the other investors. From a legal and business point of view, there isn’t always a bright line between granting preferential rights and supplemental rights to an investor.
Side letters can cover a vast range of topics, including:
legal, tax, or regulatory issues that are specific to an investor, but not necessarily applicable to other investors in the fund, and which require additional representation and warranties
investment restrictions or guidelines applicable to a specific investor such as environmental, social and governance (ESG) considerations and Shariah-compliant investments
co-investment rights
management fee and carry/performance fee reductions
liquidity rights
enhanced reporting and other transparency rights
clarification of excused rights provisions
sovereign immunity
implementation of powers of attorney
membership to investor advisory committees
most favoured nation clauses (MFN).
Although it's possible for the manager of a fund to attempt to avoid issuing side letters to investors, in practice this goal is very difficult to achieve. Some side letter arrangements, such as fee provisions, liquidity and redemption provisions, pose greater concern than others. As discussed below, side letters also raise administrative (keeping track of different arrangements) and regulatory challenges.
ADGM fund managers and funds must also consider their common law fiduciary duties. Managers should also adopt best corporate governance practices. They should seek legal advice to make an informed decision as to whether side letter provisions are permissible or enforceable.
Rules governing side letters of DIFC and ADGM funds
With a close to 20-year track record, the DIFC, located in Dubai, has established itself and the UAE as a leading international financial centre and has served as a hub for regional and international financial institutions including fund managers. The ADGM, located on Al Maryah Island, Abu Dhabi, was established in 2013 as Abu Dhabi’s financial services free trade zone.
Over the last decade, the ADGM has developed into a broad financial services hub for local, regional and international entities seeking to do business in the GCC countries and the wider region. The DIFC and the ADGM are currently achieving record-breaking growth and have attracted many of the world’s largest hedge fund and private equity managers.
Both jurisdictions offer:
the opportunity to establish a 100% foreign owned entity
0% local free zone tax rate (with potential for exemption from the new UAE corporate tax subject to certain conditions)
the ability to repatriate profits and capital
an English language, common law jurisdiction[1], with entities operating in the ADGM/DIFC being exempt from the application of UAE Federal and Emirate-level laws on civil and commercial matters[2]
an independent and modern two-tiered court system
an independent financial services regulator and registrar.
[1] Generally, the DIFC has a set of laws which are based on the common law of England while the common law of England (including the principles and rules of equity) shall apply and have legal force in, and form part of the law of the ADGM, subject to certain amendments made by the ADGM to English statutes.
[2] UAE criminal laws apply.
The DIFC and the ADGM have adopted sophisticated funds legislation governing fund managers and investments funds, including private equity, infrastructure, credit, venture capital and hedge funds. Corporate (including cell companies), limited partnership and trust structures are available.
The main fund legislation in the DIFC is the Collective Investment Law, DIFC Law No. 2 of 2010 (as amended) and the Collective Investment Rules in the DFSA Rulebook (together, the DIFC Rules). The main fund legislation in the ADGM is the Fund Rules (as amended) (the ADGM Rules). The Dubai Financial Services Authority (DFSA) is the financial regulatory agency of the DIFC while the Financial Services Regulatory Authority (FSRA) is the financial regulatory agency of the ADGM.
For the purposes of this article, our focus is on DIFC and ADGM fund managers of ‘Exempt Funds’ (requiring a minimum initial subscription of US$50,000) and ‘Qualified Investor Funds’ (requiring a minimum initial subscription of US$500,000) which are both non-retail funds that can offer their securities only to ‘professional clients’ on a private basis.
The statutory duties of DIFC and ADGM fund managers include, but are not limited to, the following:
(a) acting honestly
(b) exercising the degree of care and diligence that a reasonable person would exercise if he were in the fund manager’s position; and
(c) treating the investors who hold interests of the same class equally and investors who hold interests of different classes fairly.
The offering document of DIFC or ADGM funds must not contain any provision which is unfairly prejudicial to the interests of investors generally or to the investors of any class of securities.
Specifically, with regards to side letters, the ADGM Rules state that an ADGM fund manager must disclose in the ADGM fund’s offering document:
(a) a description of how the fund manager ensures a fair treatment of investors; and
(b) a statement as to the fund manager's ability (if any) to enter into side-letter arrangements with investors.
Points (a) and (b) are also de facto market practice disclosure provisions in the offering document of a DIFC domiciled fund.
The offering document of a DIFC or ADGM fund must not contain any provision which is unfairly prejudicial to the interests of investors generally or to the investors of any class of securities.
The ADGM and DIFC fund side letter legal considerations above are not exhaustive. ADGM fund managers and funds must also consider their common law fiduciary duties. Managers should also adopt best corporate governance practices. They should seek legal advice to make an informed decision as to whether side letter provisions are permissible or enforceable.
Moreover, a fund manager should share the side letter internally with its senior staff including investment professionals (particularly in respect of any investment restrictions), tax professionals, accounting, legal and compliance staff. It is important that all parts of the organisation can implement the terms of the side letter negotiated with investors. Lengthier side letters will add costs to the drafting process and often cause compliance challenges in terms of implementation and monitoring.
International developments
On 23 August 2023, the US Securities and Exchange Commission (SEC) adopted new rules under the Investment Advisers Act of 1940, as amended (the Rules) that affect how advisers of private funds will approach investment term negotiations with fund investors, including side letters.
The Rules concern requirements to distribute quarterly statements, mandatory private fund audit rules, conditions to adviser-led secondaries, restrictions on certain activities including recouping some expenses and borrowing arrangements with funds and restrictions on preferential treatment to certain investors.
In their initial analysis, the Institutional Limited Partners Association (ILPA) welcomed the adoption of the Rules and appreciated the SEC’s intention to promote greater governance, alignment, and transparency across private funds while several industry associations filed a lawsuit challenging the SEC’s authority to issue the Rules. We will leave it to our US law qualified colleagues to provide an analysis regarding the Rules but it is clear that these Rules will impose significant compliance burdens on managers and bring major changes as to when and how side letters will be permitted.
While the SEC takes centre stage in the private funds industry with these Rules, regulators in other global financial centres will inevitably re-examine their private funds regulatory framework. The Financial Times recently reported that the UK Financial Conduct Authority (FCA) was preparing a review of valuations in private markets.
Managers should review their current policies and practices, in particular in regard to side letters, to determine whether changes are required to comply with new regulatory requirements or as an industry best practice.
The path forward
Granting supplemental or preferential investment terms to select investors inside letters brings into question whether fund managers and funds that grant such rights are fulfilling their fiduciary duties to all investors.
Legal advice should be taken in respect of side letters. Following the adoption of the SEC Rules, it will be interesting to see if the DFSA and FSRA provide guidance on the application of DIFC/ADGM manager’s statutory obligation to treat investors who hold interests of the same class equally.
