Implementation Standards for Side Letters & Differential Rights in AIFs

What are the various types of differential rights on which side letters can be issued by AIFs to its investors

The Standard Setting Forum for AIFs (SFA), in consultation with SEBI, recently issued Implementation Standards on how Alternative Investment Funds (AIFs) may grant differential rights—often through side letters—without undermining the interests of other investors.

Below is a detailed analysis of the same:

A. Context & Background

(i) Regulatory Basis (Proviso to Regulation 20(22) of AIF Regulations)

SEBI has clarified that Alternative Investment Funds (AIFs) may offer “differential rights” to certain investors, as long as these do not harm or reduce any other investor’s rights.

(ii) Key Guiding Principles for issuing side letters

a. No Additional Liability to Other Investors Any special arrangement with one (or a subset of) investor(s) must not create or transfer additional liabilities to the rest of the fund’s investors.

b. No Enhanced Control Through Non-Commercial Rights Non-monetary (i.e., non-fee or non-economic) terms offered to select investors must not give them “control” over fund operations/decision-making, unless they are formally part of a committee under Regulation 20(7).

c. No Alteration to Other Investors’ Existing Rights Granting one investor a differential right should not undercut or modify the contractual rights of others.

d. Transparent Disclosure Any such special/differential right—and who qualifies for it—must be clearly stated in the Private Placement Memorandum (PPM) or the relevant legal/fund documents.

(iii) Standard Setting Forum for AIFs (SFA)

SEBI has directed the SFA to prepare an implementation framework and a “positive list” of differential rights that can be offered without contravening the above guiding principles. This list can be reviewed and updated periodically.

B. The List of 10 Differential Rights for which side letters can be issued

 The Implementation Standards set out 10 specific categories in which an AIF may grant differential rights to select investors. These typically take the form of side letters that modify or add to certain rights for specific investors.

Below is an overview of each category for which differential rights that may be offered by AIFs to investors:

1. Fund Expenses

An AIF may waive or reduce the expenses charged to certain investors, or may structure the way expenses are charged differently for them.

Important Constraint: If any such arrangement leads to increased expenses for other investors, the manager/sponsor of the AIF must bear that additional cost (so that no other investor is worse off).

2. Management Fees

Management fees may vary in quantum (size), method (e.g., based on net invested capital vs. committed capital), or basis across different investors.

3. Hurdle Rate of Return

An AIF can offer different hurdle rates to select investors. (The hurdle rate is the minimum return the manager must achieve before receiving any performance-based compensation like “carried interest.”)

Illustrative Example

To entice an institutional investor to commit a large ticket size at an early close, the fund manager agrees to provide a higher hurdle rate of 12% for that investor compared to 10% for others—thus, that investor would see performance fees/carry kick in later.

4. Carried Interest

The manager can negotiate different carried interest calculations  for select investors, as long as it doesn’t adversely affect other investors.

Illustrative Example

A large sovereign wealth fund invests on the condition that it pays a reduced carry rate (15% instead of 20%) if the fund hits certain performance thresholds.

5. Co-Investment Rights

The AIF may offer co‐investment opportunities to certain investors, allowing them to invest alongside the main fund in specific deals.

Shared or “common” expenses (e.g., due diligence costs for co‐invest deals) must be divided proportionally between the AIF and the co‐investors.

6. Reporting and Information Rights

Certain investors can receive more frequent or more detailed reports than the general investor base.

This cannot include unlawful disclosures or disclosures that should otherwise be given to all investors (i.e., it cannot be used to circumvent general reporting obligations).

Costs for such custom reporting go either to the investor enjoying the extra benefit or to the manager—never to the other investors.

7. Representation on Committees Constituted by the AIF/Scheme

Certain investors can have the right to nominate or appoint a member to committees that the AIF or scheme sets up (e.g., advisory committees, investment committees—if permitted by regulation).

The arrangement can address the committee member’s term, compensation (if any), voting rights, resignation, and so forth, but it must remain consistent with Regulation 20(7) (which addresses the permissible role of investors/nominees in committees).

8. Most Favoured Nation (MFN)

Some investors can get a Most Favoured Nation (MFN) clause, meaning if the fund grants better terms to any future investor, these MFN-protected investors can elect to receive the same beneficial terms.

9. Confidentiality of Investors’ Details/Information

The AIF can share other investors’ details with a particular investor, provided that it obtains specific and explicit consent from those “other investors.”

In short, if Investor 1 consents, the AIF can reveal Investor 1’s identity or certain details to Investor 2—this often arises in funds where certain investors want to know the identity or background of co‐investors before committing.

10. Representation and Warranties

The AIF can give representations and warranties (e.g., confirmations about regulatory compliance, manager obligations) to certain investors.

Such representations/warranties, however, must not result in additional special “substantive rights” or controls that other investors do not have.

C. Additional Observations and Clarifications

• Information “Elaborating on Existing Terms” Is Not a Differential Right
• Special Treatment for Regulatory Compliance Is Not a Differential Right
• Mechanism for Updating the Positive List If an AIF or an industry association identifies a differential right that is not in the current list but meets the conditions in the Circular (Paragraph 12), they can approach the SFA or relevant industry bodies to have it considered for addition to the list, after consultations with SEBI.

D. Putting It All Together

• No Adverse Impact on Other Investors: A recurring theme is that these differential rights must not impose an added cost or diminished return on any investor who is not party to that side letter.
• Disclosure Requirement: All such arrangements must be disclosed in the PPM or via an amendment so that prospective investors understand their existence and the eligibility criteria.
• Regulatory Oversight: SEBI, through the SFA, has outlined these 10 permissible areas. If an AIF contemplates any bespoke arrangement outside this list, it should ensure it still meets all the principles in Paragraph 12 and ideally coordinate with the SFA/SEBI for an update to the positive list.

Final Takeaway

The Implementation Standards allow certain flexibility (through side letters or similar agreements) for investors who negotiate tailored terms—yet they impose strict safeguards to ensure that no other investor is prejudiced. The 10 specific rights represent the “safe harbor” categories of permissible differential terms, provided:

1. They do not transfer liability to other investors,
2. They do not inadvertently grant “control” (except as lawfully permitted for committee participation),
3. They do not undermine any other investor’s contracted rights, and
4. They are fully disclosed in the fund’s documentation.

This balance allows managers to customize investor terms in legitimate ways—such as discounted fees or specialized reporting—while preserving fairness and transparency in the AIF ecosystem.

Disclaimer:

This article is intended for informational purposes only and should not be construed as legal advice or opinion. The content provided is based on current regulatory guidelines and best practices, but it is always recommended to seek formal legal or professional advice tailored to your specific situation before making any decisions related to changing an AIF’s category.

Author:

Mohit Mittal is the Founder and Managing Partner at One Stop Consultants & Services LLP, specializing in structuring and setting up Alternative Investment Funds (AIFs) in Domestic and GIFT City.

You can reach him at

📞 +91-8360761718

📧mohit@onestopconsultants.com