A side letter is a separate, bilateral agreement between a GP and a specific LP that modifies, supplements, or clarifies the terms of the main limited partnership agreement (LPA) for that investor. While the LPA governs the fund’s terms for all partners, side letters allow individual LPs to negotiate customized provisions based on their size, regulatory requirements, or institutional mandates. Side letters are a standard part of fund formation and are present in virtually every institutional private fund.
The practice exists because no single set of fund terms works perfectly for every LP. A state pension plan may have legal restrictions on investing in certain sectors. A sovereign wealth fund may require specific reporting formats or audit rights. A large endowment committing $100M may reasonably expect a fee discount that would not be offered to a $5M investor. Rather than restructuring the entire LPA to accommodate each investor’s requirements, the GP negotiates side letters that address these needs on a case-by-case basis. The result is a web of bilateral agreements layered on top of the main fund documents.
The most common side letter provisions fall into several categories. Fee modifications are the most straightforward: large LPs negotiate reduced management fees or carried interest in exchange for their commitment size. Co-investment rights give specific LPs priority access to direct investment opportunities alongside the fund. Opt-out provisions allow LPs to exclude themselves from investments that conflict with their investment policies or regulatory constraints. Enhanced reporting requirements give certain LPs access to more detailed portfolio data, more frequent updates, or specific ESG metrics. Transfer provisions may give an LP greater flexibility to sell or transfer their fund interest on the secondary market.
The most favored nation (MFN) clause is the mechanism that keeps side letter negotiations from becoming entirely one-sided. An MFN clause, typically available to LPs above a certain commitment threshold, gives the LP the right to adopt any more favorable terms granted to other investors via their side letters. After all side letters are finalized (usually at final close), the GP circulates a redacted summary of material side letter provisions, and MFN-eligible LPs can elect to receive the benefit of specific terms. Not all provisions are MFN-eligible. Terms tied to regulatory requirements or provisions that are specific to an LP’s legal structure are typically excluded.
For emerging managers raising capital, side letter negotiations can be one of the more time-consuming aspects of the fundraise. Each institutional LP’s legal team will present a list of requested provisions, and the GP must evaluate each request against the fund’s economics, operational capacity, and fairness to other investors. Granting too many fee concessions can erode the fund’s economics. Granting inconsistent terms across LPs creates complexity for fund administration. The practical approach is to establish clear boundaries before the fundraise on which terms are negotiable and which are not, work with experienced fund formation counsel, and use the MFN mechanism to provide a baseline of fairness across the investor base.
Frequently Asked Questions
What terms are typically negotiated in side letters?
The most commonly negotiated provisions include fee discounts (reduced management fee or carry for large commitments), co-investment rights, most favored nation (MFN) clauses, opt-out rights for specific investments (e.g., tobacco, gambling), enhanced reporting or transparency requirements, transfer restrictions, and key person provisions. Regulatory accommodations for government pension plans are also common.
What is a most favored nation (MFN) clause?
An MFN clause gives an LP the right to receive the benefit of any more favorable terms granted to other LPs via their side letters. After all side letters are executed, the GP circulates a summary and MFN-eligible LPs can elect to adopt specific provisions. MFN rights are typically subject to minimum commitment thresholds and may exclude certain categories of terms.
Are side letters disclosed to other LPs?
It depends on the fund's MFN provisions and regulatory requirements. Most funds with MFN clauses provide a summary of material side letter terms to eligible LPs so they can exercise their MFN rights. The SEC's new private fund rules (adopted in 2023, though subject to legal challenge) included provisions around side letter transparency, reflecting regulatory interest in ensuring equitable treatment of investors.
