Side Letters and MFN Elections in Private Equity Funds

In the private equity fund formation process, the limited partnership agreement governs the economic and governance relationship between the general partner and all limited partners on a collective basis. Side letters are the mechanism by which that collective framework is individualized for specific investors. A side letter supplements or modifies the LPA for a particular LP, granting that LP rights, protections, or economic terms that the broader investor group does not share. The most favored nation clause is the contractual mechanism by which those individualized rights can propagate to other eligible LPs, subject to defined thresholds, categories, and carve-outs.

This sub-article is part of the PE Fund Formation Legal Guide. It addresses what side letters are and why institutional LPs demand them, the principal categories of side letter terms (fee discounts, MFN rights, co-investment rights, advisory committee seats, reporting enhancements, regulatory representations, transfer rights, and excuse rights), MFN clause mechanics including tiered commitment thresholds and carve-out structures, the SEC marketing rule framework for disclosure of preferential treatment, ILPA best practices on side letter transparency, Advisers Act fiduciary considerations when granting preferential terms, ERISA LP side letter requirements, sovereign wealth and tax-exempt LP terms, regulatory LP requirements driven by BHCA, Volcker, and public pension statutes, the MFN election process from notice through effectuation, side letter administration across the fund's life, and common drafting failures that generate disputes.

Acquisition Stars advises fund sponsors, institutional LPs, and placement agents on fund formation, side letter negotiation, and ongoing LP relations compliance. Nothing in this article constitutes legal advice for any specific transaction or fund.

What Side Letters Are and Why LPs Demand Them

A side letter is a bilateral written agreement between a fund's general partner and a single limited partner that supplements, modifies, or clarifies the LP's rights and obligations under the main limited partnership agreement. Side letters become effective when countersigned by both parties and operate alongside the LPA rather than amending it for all investors. The rights granted in a side letter are specific to the executing LP and do not automatically extend to other LPs unless those other LPs hold applicable most favored nation rights and elect the relevant terms within the prescribed election window.

LPs demand side letters for several distinct categories of reasons. Institutional investors with large commitments use their capital leverage to negotiate economic improvements over the standard terms, including management fee discounts and carried interest reductions that would not be available to smaller LPs. LPs with specific regulatory obligations, including ERISA-covered plans, bank holding companies, and sovereign wealth funds, require representations and covenants from the GP that reflect the LP's own compliance posture. Tax-sensitive investors require representations addressing unrelated business taxable income and effectively connected income exposure. LPs with governance responsibilities to their own stakeholders, such as public pension funds and endowments, often require enhanced reporting that allows them to demonstrate appropriate oversight of their alternative investment programs. Co-investment-focused LPs negotiate direct co-investment rights as a mechanism to deploy additional capital alongside the fund in individual transactions at reduced or no fees.

From the GP's perspective, side letters are a fundraising tool. The willingness to grant favorable terms to a cornerstone investor or an anchor LP that commits early and at scale allows the GP to build momentum and credibility in the market. Side letters also allow GPs to accommodate the specific compliance requirements of diverse investor categories, expanding the potential LP universe beyond what a single standard LPA could serve. The cost of this flexibility is administrative: each side letter creates an ongoing operational obligation, and the aggregate of side letter commitments must be tracked, honored, and disclosed throughout the fund's life.

Common Categories of Side Letter Terms

Fee discount provisions are among the most frequently negotiated side letter terms. An LP committing above a defined threshold may negotiate a reduced management fee rate, a tiered fee schedule, or a waiver of the organizational expense allocation. Carried interest modifications are also common, including reduced carry rates for specific LPs or altered hurdle and catch-up structures. Fee offset provisions that credit transaction and monitoring fees against the management fee at a higher rate than the LPA's standard offset percentage are a related category.

Co-investment rights grant the LP the contractual right to participate alongside the fund in transactions sourced by the fund, typically on a no-management-fee, no-carried-interest basis. Co-investment rights are among the most valuable economic terms an LP can negotiate, because they allow the LP to deploy additional capital in the GP's identified opportunities at structural cost advantages. The scope of co-investment rights varies significantly: some side letters grant a right of first offer on co-investment capacity in all qualifying transactions; others grant rights only in specific deal types or above certain investment sizes. Because co-investment capacity is finite, co-investment rights are a common subject of carve-outs in MFN clauses, as discussed below.

Advisory committee seats give the LP the right to designate a representative to the fund's LP advisory committee, which typically reviews and approves conflicts of interest, valuations, and other matters reserved for LPAC consideration under the LPA. Transfer right modifications grant the LP broader or different rights to assign or transfer its fund interest than the standard LPA allows. Excuse rights allow the LP to opt out of specific investments without being excused from the fund entirely, which is particularly important for LPs with conflict of interest policies, geographic investment restrictions, or sector exclusions arising from their own governance mandates.

MFN Clause Mechanics: Tiered Thresholds, Categories, and Carve-Outs

A most favored nation clause in a fund side letter or LP agreement grants the holding LP the right to receive any more favorable terms granted to other similarly situated LPs in separate side letters, subject to the specific parameters of the MFN. The fundamental purpose of the MFN is to prevent the GP from fragmenting the investor base into favored and disfavored tiers without disclosing and offering those differences to eligible investors. MFN clauses are a standard feature of institutionally negotiated fund documents, though their scope, thresholds, and carve-outs vary considerably across fund sponsors and fund vintages.

Tiered MFN structures define different levels of MFN coverage based on the LP's commitment size. A common architecture uses two or three commitment tiers. At the highest tier, LPs committing above a specified minimum (such as $50 million or $100 million, depending on fund size) receive a broad MFN covering economic terms, reporting terms, governance terms, and transfer terms. At an intermediate tier, LPs above a lower threshold receive an MFN limited to reporting and governance terms but not economic modifications. Below the lowest threshold, no MFN rights attach. This tiered structure allows GPs to use favorable economic terms as a differentiated incentive for large commitments while still extending meaningful protections to mid-size LPs.

Carve-outs limit what terms are visible and electable under the MFN, regardless of tier. Standard carve-outs exclude: terms granted to the GP, its principals, employees, and their affiliated entities; terms conditioned on a commitment level greater than the electing LP's commitment; terms granted to accommodate a specific LP's regulatory requirements that are not applicable to the electing LP; co-investment rights, on the basis that co-investment capacity is finite and cannot be replicated for every electing LP; terms granted to a fund-of-funds or other LP category whose structure is materially different from the electing LP; and terms granted in connection with a seed or anchor investment made before the fund's initial close. The breadth and precision of these carve-outs is a frequent point of negotiation, with LPs seeking narrow carve-outs and GPs seeking broad ones.

SEC Marketing Rule and Side Letter Disclosure

The SEC's amended marketing rule, Rule 206(4)-1 under the Investment Advisers Act, which became effective for registered investment advisers in November 2022, imposes disclosure obligations on advisers who offer or grant preferential treatment to investors in private funds. The rule addresses side letters directly by requiring advisers to disclose the existence of preferential treatment to all current and prospective investors. The disclosure framework has two distinct components: prospective disclosure and retrospective disclosure.

Prospective disclosure requires the adviser, when marketing the fund to prospective investors, to inform them of any preferential liquidity rights granted to other investors and of any other preferential treatment that would have a material effect on a prospective investor's decision to invest. This disclosure must be provided before the prospective investor's investment. In practice, fund sponsors typically address this requirement through offering memorandum language that describes the existence and general nature of side letters, confirms that certain LPs may have received preferential terms, and directs prospective investors to request additional information. The prospective disclosure does not require revealing the specific economic terms of other LPs' side letters.

Retrospective disclosure requires the adviser, at or before the end of the calendar quarter in which the fund's final closing occurs, to provide all existing investors with a written notice disclosing all preferential treatment granted to investors in the same fund. This notice must identify the categories of preferential treatment and, for preferential liquidity and reporting rights, provide sufficient detail that investors can assess whether those rights would have been material to their own investment decision. GPs who fail to provide compliant prospective and retrospective disclosure risk marketing rule violations, which can result in SEC enforcement action, civil penalties, and reputational consequences during future fundraising.

ILPA Best Practices on Side Letter Transparency

The Institutional Limited Partners Association has published detailed guidance on side letter practices reflecting the expectations of institutional LP investors. ILPA's principles advocate for a default posture of transparency, recommending that GPs disclose the existence of all side letters to the fund's entire LP base and make the full text of all side letters available to LP advisory committee members. ILPA's view is that LPAC members cannot effectively discharge their oversight responsibilities unless they have access to the full scope of LP rights across the fund's investor base.

ILPA recommends that MFN rights be included as a standard term in all LP agreements, including those of smaller LPs who may lack the leverage to negotiate MFN rights independently. The ILPA model LPA provisions include broad MFN coverage with narrow, enumerated carve-outs, and ILPA has expressed concern that GPs sometimes structure carve-outs so broadly that MFN rights become effectively illusory for most LPs. ILPA has also recommended that GPs adopt a uniform side letter template applicable to all LPs, with individualization limited to LP-specific regulatory representations and commitment-size-dependent economic terms, rather than treating every LP negotiation as a blank-slate exercise that produces maximally divergent documents.

While ILPA guidance is not legally binding, institutional LPs treat adherence to ILPA principles as a signal of GP quality and LP-aligned governance. GPs who deviate significantly from ILPA recommendations without explanation may encounter resistance from LPAC members, difficultly retaining institutional LP commitments in successor funds, and friction in LP annual meeting discussions. The alignment between ILPA recommendations and the SEC's marketing rule disclosure requirements has strengthened the practical incentive for GPs to adopt transparent side letter practices.

Advisers Act Fiduciary Considerations for Preferential Treatment

Registered investment advisers that manage private equity funds owe fiduciary duties to their clients under the Investment Advisers Act of 1940. The SEC has consistently taken the position that an investment adviser's fiduciary duty encompasses both a duty of loyalty (requiring the adviser to act in the client's best interest and to avoid placing its own interests ahead of the client's) and a duty of care (requiring the adviser to provide investment advice based on a reasonable understanding of the client's objectives and circumstances). Side letters that grant preferential treatment to specific LPs raise fiduciary questions about whether that preferential treatment is consistent with the GP's obligations to the fund and its broader LP base.

The SEC has identified preferential treatment as a significant conflict of interest that registered advisers must disclose and address. Granting one LP liquidity rights that are unavailable to other LPs in the same fund, for example, can disadvantage the non-electing LPs if the preferential LP exercises those rights at a time that forces the fund to liquidate positions at suboptimal valuations. Similarly, granting co-investment rights selectively creates a conflict between the GP's obligation to maximize returns for the fund and the GP's interest in maintaining the investment relationship with the co-investing LP. The SEC's Form ADV and the marketing rule both require advisers to disclose these conflicts, and advisers must have procedures for identifying, evaluating, and addressing preferential treatment conflicts on an ongoing basis.

Advisers who grant preferential treatment that materially and adversely affects other investors without adequate disclosure and conflict management procedures face potential Advisers Act violations. This includes situations where a preferential LP's liquidity rights, information rights, or other entitlements effectively enable that LP to act on non-public fund information in a manner that places other LPs at a disadvantage. GPs and their legal counsel should evaluate each proposed side letter term not only for its contractual validity but for its potential impact on the GP's fiduciary posture vis-a-vis the non-electing LP base.

ERISA LP Side Letter Requirements

When a limited partner in a private equity fund is an employee benefit plan subject to the Employee Retirement Income Security Act of 1974, or when such a plan holds more than a de minimis interest in the fund, ERISA's plan asset rules become a central concern for the fund's structure. Under the Department of Labor's plan asset regulations, if the interests in the fund held by ERISA-covered plans and certain other benefit plan investors constitute 25 percent or more of any class of equity interests in the fund, the fund's underlying assets are treated as plan assets of the investing plans. This plan asset characterization subjects the fund's GP and investment manager to ERISA's fiduciary standards and prohibited transaction rules, significantly expanding regulatory exposure.

ERISA LPs routinely require side letter provisions addressing the plan asset question. These provisions typically take one of two forms: a representation from the GP that the fund qualifies for an exemption from the plan asset rules (most commonly the operating company exception or the venture capital operating company exception under the DOL regulations); or a covenant from the GP to monitor ERISA LP participation and to take specified actions, which may include ceasing to accept additional ERISA LP capital or restructuring the fund, if the 25 percent threshold is approached. Some ERISA LP side letters include provisions requiring the GP to notify the ERISA LP if ERISA-covered benefit plan investor participation in the relevant class of interests approaches the threshold.

ERISA LP side letter provisions also frequently address the LP's own fiduciary obligation to monitor its alternative investments. These provisions may include enhanced reporting obligations (portfolio company financial statements, valuation methodologies, expense allocations), access rights for the LP's own internal audit or external fiduciary consultants, and representations from the GP regarding the absence of prohibited transactions in connection with the investment. ERISA LP terms are commonly carved out of MFN coverage on the basis that they reflect obligations specific to the ERISA plan's regulatory situation and are not transferable to LPs that are not ERISA-covered entities.

Sovereign Wealth and Tax-Exempt LP Terms

Sovereign wealth funds and governmental LPs investing in private equity funds often require side letter provisions addressing sovereign immunity, applicable investment mandates, and the fund's treatment of transactions involving the LP's home jurisdiction or its domestic industries. Sovereign immunity provisions typically include representations from the LP confirming its status as a foreign governmental entity and from the GP confirming its compliance with applicable laws governing transactions with governmental entities. Some sovereign wealth fund side letters also include provisions addressing the fund's obligations if the LP is subject to sanctions or export control restrictions that arise during the fund's term.

Tax-exempt LPs, including university endowments, foundations, and charitable organizations, are subject to federal income tax on unrelated business taxable income. Private equity fund income that constitutes UBTI, particularly income derived from debt-financed investments, can expose tax-exempt LPs to federal income tax at rates applicable to corporations. Tax-exempt LP side letters typically require the GP to represent that the fund does not use a level of leverage that would create material UBTI exposure, or alternatively to provide advance notice before the fund enters into a leveraged transaction so that the tax-exempt LP can assess its UBTI exposure and, if necessary, restructure its participation through a blocker corporation.

Non-US tax-exempt LPs may also require representations addressing effectively connected income, which arises when a non-US person earns income that is treated as connected to a US trade or business. PE fund income from operating companies that conduct business in the United States can generate ECI for non-US LPs, creating withholding tax obligations and US tax return filing requirements. Non-US sovereign and tax-exempt LP side letters frequently address ECI risk through GP representations regarding the fund's investment activities and through provisions obligating the GP to notify the LP if the fund's investment activity is expected to generate ECI exposure above specified thresholds.

Regulatory LP Requirements: BHCA, Volcker, and Public Pension Terms

Bank holding companies and their subsidiaries investing in private equity funds are subject to the Bank Holding Company Act and, since the Dodd-Frank Act's implementation, the Volcker Rule's restrictions on proprietary trading and investment in covered funds. Under the Volcker Rule, a banking entity generally may not acquire or retain an ownership interest in, sponsor, or have certain relationships with a covered fund. The covered fund definition under the Volcker Rule's implementing regulations captures most private equity funds structured as partnerships, but the rule provides exemptions for certain fund types and for banking entity investments that meet specified criteria, including the permitted investment exemption that allows a banking entity to invest up to 3 percent of a qualifying fund's total interests, subject to additional limitations on the banking entity's aggregate investments in covered funds.

BHCA LP side letters require the GP to represent that the fund qualifies for an applicable Volcker Rule exemption, or to covenant that the fund will not engage in activities that would cause the banking entity LP's investment to violate the Volcker Rule. These representations are typically paired with a covenant from the GP to notify the BHCA LP if fund activities change in a manner that affects the LP's Volcker Rule analysis, and with a provision allowing the BHCA LP to transfer or withdraw its interest if a Volcker Rule violation is imminent. BHCA and Volcker Rule side letter provisions are carved out of MFN coverage because they are specific to banking entity LPs and do not translate to LPs in other regulatory categories.

Public pension fund LPs are subject to state investment statutes and regulations that may impose requirements on their alternative investments, including placement agent disclosure mandates, pay-to-play restrictions, co-investment and separately managed account restrictions, and mandatory investment committee reporting formats. Public pension side letters address these requirements through GP representations regarding compliance with applicable placement agent disclosure laws, covenants regarding the fund's management of political contributions by affiliated persons, and agreement to provide reporting in formats compatible with the pension's statutory reporting obligations. Several states have adopted placement agent disclosure laws requiring GPs to disclose placement agent compensation arrangements to the pension's investment staff and board, and some states prohibit pension investments in funds where undisclosed placement agent fees are involved.

The MFN Election Process: Form, Timing, and Disclosure

The MFN election process begins with the GP's delivery of an MFN notice to each LP holding MFN rights. This notice is typically delivered at or shortly after each closing, with a final comprehensive notice delivered after the fund's final closing. The MFN notice describes the categories of preferential terms granted to other LPs in side letters that fall within the scope of the MFN, organized by category rather than by LP identity to preserve the confidentiality of individual LP side letter terms. The notice specifies the election window within which the MFN holder must communicate its elections to the GP.

The election window is typically 30 to 60 days from the date of the MFN notice. MFN elections must be made in writing and specify which terms the electing LP wishes to adopt. The election is generally irrevocable upon delivery to the GP. Upon timely and valid election, the elected terms are incorporated into the electing LP's side letter or are deemed effective as of the date of the election (or in some structures, as of the fund's initial closing, so that the electing LP receives retroactive benefit). Elections made after the election window has closed are typically ineffective unless the GP waives the deadline, and most side letter MFN clauses specify that failure to elect within the window constitutes a waiver of the right to elect those terms.

The level of disclosure provided in the MFN notice is a recurring point of tension between GPs and MFN holders. GPs typically wish to describe preferential terms in general categorical terms (e.g., "certain LPs have received a management fee discount in excess of the standard rate") rather than providing the specific economics (e.g., "LP X pays a 1.25% management fee rather than the standard 1.5% rate"). MFN holders want sufficient specificity to determine whether a disclosed term would be beneficial if elected. Fund documents vary considerably in how much disclosure detail is required: some LP agreements specify that the MFN notice must include sufficient information to allow the electing LP to make an informed election decision, which may require more specific disclosure than a purely categorical description. Disputes over the adequacy of MFN notice content are among the most common side letter-related conflicts in the market.

Side Letter Administration and Tracking Across the Fund's Life

Side letter administration begins at fund closing and continues until the fund's final distribution and wind-down. The operational scope of ongoing side letter administration is broader than many first-time fund managers anticipate, because each side letter's obligations must be tracked and honored independently of the LPA's uniform requirements. GPs must maintain a central repository mapping every LP's side letter entitlements across every category, updated to reflect MFN elections made after each closing.

Co-investment right administration requires the GP to identify transactions that qualify as co-investment opportunities under the applicable side letter definitions and to deliver timely written notice to each LP holding co-investment rights. The notice must comply with the contractual specifications regarding content (investment description, structure, economics, contemplated timeline) and timing (typically five to ten business days before the co-investment closes). LPs who do not respond within the specified response window are typically deemed to have declined. GPs must document each co-investment notice and each LP's response to create a compliance record demonstrating that co-investment rights were honored.

Reporting enhancement obligations require the GP's investor relations function to maintain separate reporting tracks for LPs with customized reporting requirements. These customized deliverables may include quarterly portfolio company financial statements, ESG metric reports, fee and expense transparency schedules, and valuation methodology disclosures. Integrating these requirements into the GP's standard reporting calendar requires coordination between the legal, finance, and investor relations teams. Regulatory representation obligations require the GP to monitor each LP's regulatory status throughout the fund's life and to notify relevant LPs if fund activities create compliance exposure for that LP's specific regulatory category. A failure in any of these administrative obligations constitutes a breach of the applicable side letter, potentially exposing the GP to damages and, in cases involving regulatory representations, to indirect regulatory exposure through the affected LP.

Common Drafting Mistakes and Side Letter Disputes

The most common source of side letter disputes is ambiguity in the definition of "similarly situated" LPs for MFN purposes. If the MFN clause does not clearly specify what criteria determine whether two LPs are similarly situated, a GP may take the position that an LP electing MFN rights is not similarly situated to the LP whose favorable terms are being sought, defeating the MFN election. LPs contesting such a position must demonstrate, through extrinsic evidence or contractual interpretation, that the GP's comparability determination was incorrect. Drafting the "similarly situated" standard with specificity, including concrete commitment-size thresholds and explicit statements about what characteristics are and are not relevant to the comparability analysis, reduces this risk significantly.

Co-investment right definitions generate disputes when the scope of qualifying transactions is ambiguous. If the side letter grants co-investment rights in "fund investments" without further specification, the GP and LP may disagree about whether particular transactions, such as follow-on investments in existing portfolio companies, add-on acquisitions by portfolio companies, or investments made through separately managed accounts for other clients, constitute qualifying co-investment opportunities. Precise drafting that specifies the types of transactions, the minimum deal size that triggers the co-investment obligation, and the relationship between the fund's investment and the co-investment vehicle avoids most of these disputes.

Reporting enhancement provisions generate disputes when the scope of required deliverables outpaces the GP's operational capacity. A side letter that promises quarterly audited financial statements for every portfolio company, without understanding the timing and cost implications, creates an obligation that the GP may later be unable to fulfill. GPs should review proposed reporting enhancement terms against their actual portfolio company reporting capabilities before agreeing to enhanced deliverables in side letters. Provisions that require "commercially reasonable efforts" to obtain portfolio company financials, rather than unconditional obligations to deliver them, provide practical flexibility while preserving the LP's right to require genuine effort. Acquisition Stars structures side letter terms to reflect the full operational implications of each proposed provision, reducing the risk that obligations agreed during fundraising create administrative failures during the fund's investment period.

Frequently Asked Questions