Side Letters in a Private Fund
A side letter is a separate agreement between the fund or its sponsor and a particular investor that gives that investor terms different from the standard documents, such as a lower fee, extra reporting, or a right to transfer. Side letters are common for larger investors. Each one must be consistent with the fund documents and disclosed as the PPM requires, since undisclosed preferences can create conflicts with other investors and anti-fraud exposure.
Common side letter terms
- Fee discounts. A reduced management fee or carry for a large or early investor.
- Information rights. Additional reports, access to the sponsor or portfolio details.
- Transfer rights. Permission to transfer interests to affiliates or estate-planning entities.
- Regulatory accommodations. Provisions for ERISA plans, public pension funds and foreign investors.
- Excuse rights. The right to opt out of certain investments for legal or policy reasons.
- Co-investment. A right to participate in deals alongside the fund.
Most favored nation clauses
A most favored nation (MFN) clause lets an investor elect the better terms granted to other investors in comparable circumstances. Sponsors usually limit it by size of commitment, timing and type of investor, so a smaller investor cannot claim a larger investor's special terms. The sponsor should track all side letters and apply the MFN process carefully, since missing an election right can be a breach.
Disclosure issues
| Issue | What to do |
|---|---|
| Preferential fees or liquidity | Disclose in the PPM that some investors may receive different terms |
| Preferential information | Avoid giving some investors material information others do not get |
| Conflicts with the governing agreement | Check the agreement allows side letters and says who may grant them |
| Impact on other investors | Consider whether a term affects the economics or rights of others |
Managing them
- Keep a log of every side letter and its key terms.
- Have counsel review each letter against the fund documents.
- Use a standard menu of terms when possible, so treatment is consistent.
- Calendar any deadlines in the letters, such as MFN election periods and reporting commitments.
When an investor asks
A first-time sponsor may feel pressure to grant whatever a large investor asks. Resist agreeing to terms that conflict with the fund documents or cannot be delivered. For the underlying document terms see key terms of the governing agreement and what a PPM contains.
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Book Free ConsultationFrequently asked questions
Do all funds use side letters?
Not all, but many funds with institutional or large investors do. Small funds often have none.
Can a side letter override the operating agreement?
Only if the operating agreement allows and the sponsor has authority. Otherwise it may be ineffective or a breach.
Do other investors have to know about side letters?
Not individually, but the PPM should disclose that side letters may be granted and what types.
What is an MFN election?
A right for an investor to choose the more favorable terms given to others, within limits stated in their letter.