Part One: Overview of side letters & MFNs when investing in private equity funds

In the first of a three part series we consider the importance of side letters and most favoured nations (MFN) clauses in private equity funds.

Side letters and MFN clauses play a key role in the commercial negotiations of an investment in a modern private equity fund. In this first of a three part series, we look at a high level overview of side letters and MFNs in the private equity space.

If an investor can negotiate a side letter with the fund's sponsor, such side letter entitles that specific investor to preferential terms for their investment in the fund (e.g. a reduced management fee or co-investment rights).

The MFN clause entitles an investor to have visibility of side letter entitlements of other investors in the fund and, in certain circumstances, allows such investor to elect to benefit from those entitlements.

The MFN clause and its interaction with investor side letters and the fund documentation can result in the disclosure of investors' side letter entitlements to other investors and even the right to take the benefit of preferential terms negotiated by other investors. However, MFN clauses can also lead to a range of issues surrounding lack of transparency for investors.

Further, MFN clauses can lead to increased bureaucracy, administration and legal costs for the sponsor, i.e. typically the fund’s general partner or investment manager who establishes and promotes the fund, in negotiating and implementing complex and increasingly lengthy MFN clauses and side letters. Such side letter negotiations and the MFN election process can even delay fund closings.

MFN clauses have become a 'must have' for large institutional investors and fund sponsors should expect to receive lengthy side letter requests (invariably containing MFN clauses) and take the necessary steps to accommodate such requests as far as they deem commercially prudent.

Most private equity funds now structure the MFN drafting to include carve outs and tiering premised on the size of an investor's commitment to the fund. The effect is to deny disclosure of the terms of any other side letter to an investor that does not commit at least as much as the investor who entered into the side letter in question.

There are a number of administrative and practical steps that a sponsor can take to ensure the smooth implementation of MFN clauses and a well operating side letter election process which we will discuss in the third part of this series.