A venture capital fund may have different types of investors: individual investors or a family office making a relatively small investment, institutional investors committing large sums, and everything in between. A large investor has a different negotiating position. In venture capital practice, it is therefore not uncommon for large investors to negotiate additional rights that are set forth in side letters. These may include more detailed reporting, additional information about the portfolio companies, a right to consultation, certain approval rights, a right to audit, and so on.
For funds subject to the full AIFMD regime, the transparency requirements of the AIFMD apply: the basic principle is that investors must be treated fairly and that no investor may receive preferential treatment unless such treatment is disclosed in the relevant fund documentation. However, this does not mean that every investor must have exactly the same rights. For example, a fund may have different categories of investors, each with different economic or information rights. Additional agreements may also be made with individual investors. Differentiation is not ruled out in this way, but preferential treatment must not result in an overall material disadvantage for the other investors.
For funds that are not subject to the full AIFMD regime, this question also arises, and in my opinion, the “material detriment” criterion can also serve as a guiding principle within the civil law framework governing internal relationships in this type of fund, if the fund documentation does not contain any specific provisions on this matter.
When can unequal rights lead to a substantial disadvantage?
That is a question fund managers need to be prepared for when they grant a major investor a wide range of far-reaching additional rights. Here are two examples to illustrate this:
- A major investor is granted an audit right. This right does not necessarily have to result in a substantial disadvantage for the investors. If an audit reveals irregularities and the major investor calls on the fund manager to correct them, then all investors benefit from this. The situation is different if, thanks to their audit right, the major investor gains access to relevant information that they can use in their own investment decisions at the expense of the other investors. In that case, the audit right could potentially result in significant harm to the other investors.
- A major investor is granted the right to more information, the right to receive all requested additional information upon first request, and the right to receive information shared with all investors earlier than others. Depending on the circumstances, such rights may result in a material disadvantage. After all, this creates an information advantage, and the major investor can tailor their (investment) decisions accordingly, while the other investors do not have that opportunity. The information may also be commercially or strategically relevant in other ways. Thus, the major investor may gain a financial advantage that could result in a disadvantage for the other investors.
Points to Consider
- In assessing the admissibility of a side letter, consideration must be given, among other things, to the content and scope of the desired rights, the consequences of exercising those rights for the beneficiary investor and the other investors, any unintended consequences these rights may have, and the investor’s position. For example, an institutional investor may need additional information to comply with its own legal or regulatory obligations. This is different from a situation where an investor is granted additional rights solely because of its position.
- It is also important to consider the desired rights in relation to one another and in their broader context. On its own, a right may not cause any harm to the other investors, but is that still true if the investor exercises all of his additional rights and is thereby able to exert significant influence within the fund? And how would he use that influence?
- In my view, approval rights, extensive information rights, preemptive rights, rights that stipulate more favorable terms upon entry or exit, and agreements that establish a different cost structure always require special attention and a careful balancing of the interests involved by the fund manager.
- Under pressure from a major investor and driven by the desire to raise substantial amounts of capital, the fund manager may be tempted to grant increasingly far-reaching rights. However, in doing so, the fund manager may also maneuver himself into a difficult position. The more special rights a single investor receives, the greater their influence becomes, and the greater the likelihood that this investor will have a stronger position in terms of information and bargaining power relative to the fund manager in the event of future conflicts. Therefore, when drafting any side letter, a fund manager should not only ask, “What does this agreement mean for the position of the other investors?” but also, “In what position am I placing myself and the fund by granting these rights?” In other words: “What are the side effects of this side letter?”
