Part Three: Five practical implications of side letters and most favoured nations clauses for fund investors and managers
In this third and final part of our series on side letters and most favoured nation (MFN) clauses in private equity funds, we examine five practical implications for investors and managers.
If the MFN clause is to be contained in an investor's individual side letter it is crucial that, as far as possible, the drafting of such MFN is consistent with the drafting in other side letters. Inconsistencies in ‘tiering’ or other carve-outs create a complex and confused picture regarding which investors are entitled to have sight of which side letters, and whether they are eligible to elect to benefit from such terms. Accordingly, sponsors should take a robust approach to negotiating the drafting of the MFN clause, even when investors wish to use their ‘pro-forma’ side letter provisions.
(1) Visibility of MFNs
Visibility of side letter entitlements of other investors and the ability to elect to benefit from them is a crucial part of the modern private equity fund raising process. Investments are often dependent upon the success an investor has in the MFN negotiation process.
MFN clauses were initially drafted as a simple provision by which investors were entitled to the disclosure of side letter terms negotiated by other investors with the fund sponsor, and permitted an investor to elect to receive the benefit of any of those terms they wished to take the benefit of. Until relatively recently, the MFN clause was regarded as the ‘self-help’ remedy in an unregulated market reserved for investors that could help themselves to all, or substantially all, of the same rights as other investors. This investor friendly environment did not last for long.
‘Unregulated’ private equity funds are characterised by extremely flexible structures and can accommodate most commercially negotiated agreements. Therefore, as investors have become more sophisticated and demanding in the fund raising process, so the MFN has evolved from simply entitling investors to disclosure and possible election of preferential terms granted to other investors, to a complex and highly negotiated clause which many see as the key to a successful investment negotiation with a fund's sponsor.
(2) Project management
Since there can be many investors in some of the largest private equity funds and, dependent upon the scope of their MFN entitlements, because many of those investors are entitled to 'cherry pick' preferential terms, co-ordinating the side letter disclosure and subsequent election process can be challenging for a sponsor to manage.
Sponsors should commence capital raisings with a clear side letter strategy and consider which investors are likely to expect side letters and MFN rights, the scope of such MFN clauses and whether carve-outs can be included in the MFN. A sensible approach is to appoint a lead individual to take responsibility for the side letter election process and liaise closely with legal counsel to ensure consistency of approach.
During the fundraising process, private equity sponsors should expect to receive several requests for side letter accommodations, particularly from the larger institutional investors. Negotiation of side letters is often a laborious process and can be time consuming—even to the extent of delaying closing—and can increase legal and administrative costs significantly.
Should the investor require a legal opinion from the sponsor on the enforceability of its side letter, additional time and costs will be incurred.
(4) Standardised language and MFN carve-outs
Standardising side letter language can ease monitoring and compliance burdens on the sponsor's administrative team and also limit the number of clauses that are available for side letter election. Standard MFN carve-outs will significantly ease the burden of the MFN election process.
(5) Require affirmative action for MFN election
Investors wishing to exercise their MFN rights should be required to acknowledge their MFN elections in writing within a specified number of business days (commonly 30 business days). This approach enables investors’ flexibility to tailor elections to their particular circumstances, lessens the chance of conflicting side letter entitlements and facilitates a workable structure for ensuring compliance with side letter elections.