Behind Closed Doors: The Legal and Economic Fallout of “Side Letters” in Private Equity

[Dev is a student at Tamil Nadu National Law University.]

Private equity is a kind of financing where private or public investors provide capital to non-listed companies in lieu of acquiring equity stake. The foundation of private equity transactions lies in contracts. There are some contracts which never come into the public record yet work behind the closed doors, that are known as side letters. The nature of these is bilateral and confidentiality with limited involvement. 

Side letters work along with various principle agreements such as, limited partnership agreements, shareholder agreements, and articles of association, but behind the closed doors, offering special terms to major strategic investors such as exclusive privileges, fee concessions, governance privileges, most favoured nation elections, tax concessions for foreign limited partners, etc.  These equity deals depend heavily on these side agreements, as they enable fund managers to quickly finalize the deals by addressing investor specific demands. However, this secrecy and lack of transparency destabilize the foundation of law and governance. These agreements outmanoeuvre the principal agreements which raises which prompts the inquiry into the limits of contract enforceability. They also clash with laws requiring disclosure and equal treatment and break apart investor bargaining power. Their commercial appeal is obvious; they allow sponsors to speed up closings and solve investor specific regulatory problems that would be awkward to resolve in principal binding documentation. 

Legal Fault Lines of Side Letters in India

Beneath their commercial utility, side agreements suffer from a fundamental ambiguity in enforceability. India has no direct case dealing with enforceability of these agreements but English High Court has taken a cautious approach in dealing with such instrument; for example, in the case of Barbudev v. Eurocom, High Court mentioned that a side letter offering investment “on terms to be agreed’’ could not bind the parties due to lack of certainty. In India, Section 29 of Indian Contract Act 1872 governs such situation and invalidates any agreements where material information is uncertain. As a result, any side letters which remain vague in clauses, terms or rely on open ended commitments are susceptible to being struct down. By following proper procedures, pointing out clear formulas, timelines, and enforceable obligations drafters will prevent the situation where the instrument meant to protect investors, when challenged, becomes invalid because these elements were not present.

In India, side letters collide with the requirement of the Companies Act 2013, specifically with disclosure and parity norms. Section 117 of the Companies Act 2013 requires filing of agreements and resolution that affect shareholder rights. Side letters grant vetoes to select limited partnerships (LPs), grant preferential exits, or bespoke rights, altering rights of shareholders and triggering the law's filing and registration machinery. Yet, in most cases, the fundraisers still choose to keep the agreements secret and not disclose them to the public. This results in two major risks coming up.

1. The side letter may lack enforceability against third parties, and

2. The company and its officers may face liability exposure for statutory breaches under Indian corporate framework.

Thus, the very purpose of confidentiality that makes side letters commercially suitable simultaneously undermines their legal stability.

Equally material is re-characterisation risk. Many side letters include negative covenants, exclusivity in connection with assets, bespoke cash-sweep mechanisms, or acquisition right-of-priority. Functionally speaking, such provisions are akin to a security interest. Section 77 of the Companies Act 2013 refer them “charges” and imposes the requirement for registration; an unregistered charge is avoided in favour of creditors or a liquidator. 

Another layer of complexity arises with the framework of Insolvency and Bankruptcy Code 2016. When a non-listed company enters in insolvency and all equity holders are also private person or entities, the role of SEBI climbs down making National Company Law Tribunal (NCLT) led process applies. Side letters’ preferential exit rights directly encounter with pari passu principle of equal treatment unless they were registered as “charge” under section 77 of Companies Act 2013. Judiciary has observed that statutory distribution priorities like pari passu principle takes lead on privately bargained agreements. As a consequence, these agreements can dissolve into sand, depriving investors the very protection, side letters were meant to secure during insolvency situation.

The fiduciary overlay sharpens stakes in India. The SEBI's alternate investment funds (AIF) regime imposes an obligation on managers of funds to act honestly and equitably and safeguard investors' interests; these obligations are statutory in character and stricter among other jurisdictions. A general partner who secretly offers special-reporting or liquidity privileges to select limited partners may violate the duties of fairness and face NCLT petitions in the guise of oppression or mismanagement. SEBI's last year actions specifically aim at putting a check on side-letter privileges which deviate liability, skew control or impinge upon other investors' entitlements, a regulatory template which can be imported by the Ministry of Corporate Affairs into company law.

Economic Distortions and Strategic Behaviour: A Game-Theoretic Analysis 

Legal risks are only half of the picture. Side letters create adverse economic effects which can undermine efficient contracting. Traditionally, these agreements were seen from the lens of price discrimination where the fund sponsor attempts to charge different prices for different investors with some concessions. In contrary, in a recent empirical work, a hand collected dataset of 252 side letters shows this price discrimination to be extreme rarely (0.4%) whereas, most clauses accommodate regulatory or tax requirements. Yet, far from being harmless, side letters impose hefty transactional costs, impacting both the fundraiser and investors financially.

In India, the effects of side letters from an economic point of view are more of a system-wide nature rather than being incidental. The private capital market in India has a very noticeable differential and asymmetrical growth pattern, especially in the AIF sector. As per SEBI data, total AIF investments reached a whopping INR 13 trillion by December 2024, out of which more than two-thirds is in unlisted assets and is majorly contributed by institutional investors and ultra-high net worth individuals. Further, the economic dynamics of side letters reduces competition, creates oligopolistic equilibrium. To understand this better, the relationship between a large anchor investor and a smaller institutional investor can be modelled as non-cooperative strategic game.

Let us assume, there are two representative investors in an Indian private equity fund:

1. LP₁ : a large anchor investor

2. LP₂ : a small institutional investor

Both have 2 different choices:

1. C (cooperate): accept terms without side letters

2. D (defect): negotiate for side letter for preferential treatment.

The payoff matrix outcome:

	LP2 : C	LP2 : D
LP1 : C	(+3, +3) – Pareto efficient	(-1, +4) – LP2 gamins benefit and LP1 loses relative value
LP1 : D	(+4, -1) – LP1 gamins benefit and LP2 loses relative value	(+2, +2) – both incur transactional costs

In the payoff matrix, each of the cell represents the utility (Ui) of an investor, defined as:

Ui=Ri-Ti+Ii

Whereas:

• Ri= return entitlement,

• Ti= transaction costs,

• Ii= informational benefit to one of the LP.

From the payoff matrix, the collective utility is highest at (C, C) = ΣU(C,C)=+6 but both the LPs have individual incentives to defect and fear of left out by other LP in maximizing benefit. These individual benefits and fear of left out makes the highest utility outcome unstable. So, the Nash Equilibrium shifts to (D, D) as the possibility of opponent to defect is high. So: 

 U_i (D) > U_i​ (C)

Taking (D, D) as equilibrium, both the investors will experience economic distortions such as there will be higher transaction cost which will lower efficiency in the deals. High transaction costs do not affect high net worth private equity investors, that’s why they repeat their successive cycles in the market to get domination and concentration over it which ultimately stifles competition. Further, this equilibrium aligns with oligopolistic market where some investors hold big margins over others for better bargaining.

Further, confidentiality of side letters make situation worse by introducing information disequilibrium. Akerlof model in this situation suggests entry barriers, when investors cannot observe the full contractual map, adverse selection drives worse available terms for some selected investors. According to him this opacity leads to oligopolistic equilibrium where capital move only among some elite LPs and fund managers.

Thus, the side letters, even though not directly price discriminating, create a hierarchy of liquidity, information, and influence-an invisible architecture that diminishes market efficiency and investor equality thus bringing inefficiency to the market.

Conclusion and Way Forward

Side letters are not mere addendum in private equity deals. They have capability to topple a private equity transaction. While they enable fundraiser and investors to close the deal efficiently, their non-disclosure characteristic violates the principle of parity and transparency. They are placed outside of statutory registers, which brings them into direct conflict with the Section 117 of Companies Act 2013's disclosure duty and easily opens the way for treating investors unfairly. The dilemma is not just related to their presence but also to their involvement in disputes or during insolvency proceedings. A structure compliance pathway is necessary to solve these problems. This analysis supports recommendation to adopt a dual-tier filing model for compliance of Section 117 of the Companies Act 2013, that can reconcile transparency and confidentiality. In the issue of distribution of assets during insolvency, preferential right given should be registered as “charge” under Section 77 of the Companies Act 2013. In conclusion, if compliance can be achieved with reasonable confidentiality, side letters can change from being the source of hidden privileges to the instruments of orderly governance.