A side letter is a bilateral agreement between the fund and an individual limited partner that modifies or augments the standard limited partnership agreement (LPA). Side letters are a commonplace practice in institutional fundraising, with data from the Institutional Limited Partners Association showing that the vast majority of funds with an institutional LP base will contain them. Emerging managers need to understand how side letters relate to fund administration if they want to launch a clean, audit-ready fund.
What Is A Side Letter in Fund Administration?
The definition of a side letter from a fund administration perspective is a written agreement with an LP that creates an obligation for the admin that does not exist in the standard LPA. The types of provisions in side letters typically relate to economics, reporting, investor status representations, and investment restrictions specific to that particular investor. Side letters are legal, binding documents. When an LP has signed, you as the emerging manager will have to operationalize the side letter provisions that directly impact capital accounts, the reporting and the distribution with the fund admin. This is not a documentation issue, as failing to do so would result in a breach of contract with an LP.
What Is A Side Letter?
The reason LPs (pension funds, endowments, funds of funds, and family offices) negotiate side letters is because they often have legal, regulatory or internal requirements that do not fit within the standard LPA document. Rather than creating and negotiating a new LPA with each institutional LP, a side letter approach is used to tack these terms onto the standard LPA.
We are often asked to do an analysis of the first close of a $50M debut PE fund and the LP base at first close was very institutional. One LP, a state pension fund required ERISA plan assets representations, a most favored nation clause and quarterly reporting on a specific template. The two additional LPs at the first close had a different notice period and co-investment rights, each with a side letter. That was three side letters at first close with no capital calls. This is not unusual, but each one required tracking.
What Does A Fund Admin Need To Track in a Side Letter
Before the first capital call the fund admin will be required to pull the relevant provisions in each side letter that has operational or financial implication and to review that they can accommodate it. The major categories to look for in any side letter are economics, reporting, and investment restrictions. The type of provisions will drive the type of obligation to the fund admin.
Management fee modifications. You need to know about each LP with a negotiated reduction or offsets in fee amounts and which early fund years are exempt from fees or have waived management fees. That needs to be factored into every quarter calculation.
- Management fee modifications: Some LPs negotiate reduced fees, fee offsets, or waived fees in early periods. These must be reflected in each quarterly fee calculation.
- Carried interest adjustments: Preferred return modifications, carry waivers, or tiered carry structures must be modeled separately in the waterfall.
- Most-favored-nation (MFN) clauses: An MFN provision requires the manager to notify an LP if any other investor receives more favorable terms. Tracking MFN across a full LP base requires a systematic process — typically a side letter matrix updated at each close.
- Co-investment rights: Some LPs negotiate the right of first offer on co-investments. These require timely notice and tracking of LP elections on a deal-by-deal basis.
- Reporting requirements: Quarterly and annual formats, delivery deadlines, and specific data fields vary by side letter. A pension fund may require ILPA-standard templates. A family office may require a one-page summary.
- ERISA and investor status representations: LPs that are ERISA plan asset investors may require specific representations at each capital call.
- Excuse rights: Some LPs have the right to be excused from specific investments based on sector, geography, or ESG criteria.
Side letter administration has become significantly more complicated within the last three years, according to roughly 30% of fund managers surveyed by Intertrust Group in 2023. MFN clauses were found in over 60% of institutional side letters reviewed by Intertrust.
How Side Letters Impact Capital Calls
Prior to any distribution of capital call notices, make sure each notice is run through the side letter matrix. You must determine if each LP has excuse rights and if you are distributing notices to LPs with specific notice period requirements on the appropriate notice timeline.
We examined the mid-fund capital call above, and one of the key points we found in our research was that one LP had successfully negotiated a 15-business-day notice period, whereas the standard LPA term was 10-business-days. However, their notice was still sent out on a standard 10-business-day timeline. This LP was then able to validly delay funding of their capital call notice, and your fund ran into short-term cash shortage issues on the date the fund investment closed. These mistakes can easily be prevented with an up-to-date side letter matrix.
During each close, the fund admin should run a formal MFN analysis, which entails reviewing the terms of the side letter for the new LP and reviewing all existing MFN terms, determining if any of the terms contained therein would trigger the MFN rights, and then notifying the relevant LPs of the MFN rights immediately after each close of a new investor. After this, the LPs can then elect the more favorable terms, provided an election window has been granted (usually 30- to 90-days).
MFN provisions are some of the most challenging side letter provisions to administer, because MFNs are triggered by events at close. That is to say, MFN's happen when a new LP comes into the fund and is granted terms that are more favorable than a specific LP's terms that were granted upon that MFN holder's date of close.
MFN Administration for Emerging Managers
What You Should Give Your Fund Admin You should deliver your side letters to your fund admin as soon as possible for smoothest possible operations. Ideally, your fund admin will receive draft side letters as you’re negotiating them. Your admin can flag any issues in side letters that might create operational complexity you were unaware existed and may not realize is a problem until it’s too late to change. If you cannot give the fund admin advance copies, at the very least, provide fully executed copies of all side letters to your fund admin before you make your first capital call, including all amendments as they occur. Also be sure to confirm with your side letter holders to see if there are any side letters that contain verbal commitments that were not reduced to writing in the side letters.
Do all LPs get side letters? No. Typically, side letters are only entered into with an institutional investor who has regulatory or other requirements that necessitate specific accommodations. Individual high-net-worth investors and smaller family offices often invest using standard terms outlined in the LPA.
Who is responsible for enforcing the obligations of a side letter? Legally, it’s the General Partner’s (GP) obligation to meet the commitments in a side letter. In reality, it’s up to the fund admin to operationalize and meet all obligations of all side letters on behalf of the GP. The fund admin relies on the GP to provide them complete and accurate copies of all side letters and to review the final side letter matrix for accuracy.
What happens if the fund admin does not meet a side letter obligation? If an obligation in a side letter is not met, it will be considered a contractual breach with that LP. Potential consequences could be LP complaints requesting fee credits, legal action, and damage to the firm’s reputation. An MFN side letter can create a host of issues, since a failure to meet terms in one side letter might require you to provide that same concession to multiple other LPs.
How does an MFN provision work? When the fund admin identifies that a new investor has been given terms more favorable to those already available to an existing MFN LP, the GP is responsible for notifying the MFN LPs of this new benefit in a timely manner. The LPs then can choose to opt-in to the new terms. Any elected changes are recorded in the fund’s records and become effective operationsally going forward.
Can side letter terms change after fund close? Yes. The terms of any side letters can be amended at any time by mutual agreement of the parties. When the side letter is amended, a new side letter needs to be signed and provided to the fund admin and captured in the side letter matrix.
Do all LPs get side letters?
No. Side letters are typically negotiated by institutional investors that have specific regulatory or policy requirements. Individual high-net-worth investors and smaller family offices often invest on standard LPA terms.
Who is responsible for enforcing side letter obligations?
The general partner bears ultimate legal responsibility. In practice, the fund administrator operationalizes and tracks most obligations on the GP's behalf — but the GP must provide accurate side letters and review the matrix.
What happens if a side letter obligation is missed?
A missed obligation is a breach of contract with the affected LP. Consequences may include LP complaints, demands for fee credits, legal claims, or reputational damage. MFN breaches are particularly serious because they can affect multiple LPs simultaneously.
How does an MFN clause work in practice?
When a new investor receives terms better than those available to an existing MFN holder, the GP must notify that LP within the specified timeframe. The LP then decides whether to elect the new terms. Any election is documented and applied going forward.
Can side letters be amended after the fund closes?
Yes. Side letters can be amended by mutual agreement at any time during the fund's life. Amendments must be signed, provided to the fund administrator, and reflected in the side letter matrix.