Are side letters helpful to an LP?
A deep dive on side letters in real estate syndications
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.