The Terms One Investor Receives and Nobody Else Sees

The Documents Behind the Documents

A private fund is governed by a limited partnership agreement that applies to all investors. In practice that agreement is not the whole deal. Sit next to it side letters bilateral agreements between the manager and individual investors that modify the terms as they apply to that investor

They are more standard than exceptional. Large funds routinely run dozens and the added effect can be that the headline terms of the partnership agreement describe the treatment received by no one of importance

What Gets Negotiated

Several of them are entirely legitimate and reflect genuine differences among investors rather than favoritism. A public pension subject to freedom of information laws needs reporting arrangements that a family office does not. An investor who is prohibited by policy from having exposure to tobacco or firearms needs one. excuse me well allowing you to opt out of a specific agreement

Others are pure economics. Size fee discounts are ordinary volume pricing. Anchor investors who commit early when the fund has no track record and needs credibility to attract others receive better terms for taking on that risk which is the same logic as a cornerstone investor in a public offering

A Worked Example: What the Better Terms Are Actually Worth

The debate over side letters is often conducted in the language of justice. Adding numbers makes it clearer which provisions really matter and the answer is not the one that generates the most complaints

Create two investors in a $2 billion fund. Investor A commits $400 million and negotiates a management fee of 1.5 percent instead of 2 percent a seat on the advisory board and co-investment rights. Investor B commits $50 million under standard terms

Price the fare discount first. Half a percentage point of 400 million dollars is 2 million a year. More than ten years of life of the fund is 20 million dollars. Significant and it is a cost assumed by the administrator and not by anyone else in the fund

Now let's put a price on the right of co-investment which is the term that no one protests about. Let's say you allow Investor A to deploy an additional $200 million alongside the fund with no fees or carry

The money inside the twenty-two-year fund converts a gross result of 2.0 times into approximately 1.64 times net as shown by the commission arithmetic in a standard fund. Thus 200 million invested in the fund produces around 328 million. The same 200 million invested through co-investment without charging commissions produces 400 million

The co-investment right is worth approximately $72 million compared to $20 million for the fee waiver more than three times as much and is exactly the term established by most most favored nation clauses

Therefore the protection that Investor B believes he has does not reach the term of greatest value. And Investor B's own position staggered at a commitment threshold that he does not meet means that he cannot choose the commission discount either. Above $50 million in ten years the difference in fees that he cannot claim amounts to about $2.5 million

Read the last row of the table separately from the others because it is a completely different type of item. The first three cost the technician. The fourth costs the other investors which is the distinction the next section is about. These are illustrative figures and the actual terms vary wildly but the ranking is solid

The Provision That Causes the Real Problem

The terms that really hurt other investors are liquidity and information and they behave differently than commission discounts

A fee discount for one investor costs the manager not other investors. But a right that allows an investor to withdraw or transfer more freely or receive portfolio information that others do not receive can transfer value between investors and not from the manager. In a period of stress an investor with superior information or an easier exit has an advantage at the expense of those without it

This is why regulators specifically focused on preferential reimbursement and preferential information rights rather than side letters in general

How Investors Try to Protect Themselves

The instrument is the most favored nation clause according to which an investor has the right to choose any better condition granted to another investor in the same fund. It seems like a complete solution and usually it is not for several reasons

MFN duties are usually staggered by commitment size so an investor can only choose terms granted to investors of the same size or smaller. Certain categories are completely divided and commonly include terms driven by the specific regulatory or tax status of another investor and often include advisory committee seats and co-investment rights which are precisely the terms with the highest value

The process also requires the manager to disclose a schedule of supplemental terms for investors to choose from and the quality of that disclosure varies. An investor who receives a summary instead of the underlying language may not be able to assess what is declining

The Regulatory Attempt and What Happened to It

US regulators adopted rules in 2023 that address exactly these concerns including restrictions on granting preferential redemptions or information rights when they would have a material negative effect on other investors and requirements to disclose preferential terms to all investors

Industry groups challenged the rules and a federal appeals court struck them down in 2024 holding that the agency had exceeded its legal authority. The practical result is that the disclosure and fairness issues the rules address remain questions of negotiation and market practice rather than regulation putting the burden of asking back on investors

Case Study: The Rule That Lasted Ten Months

The rise and fall of those rules is worth analyzing because it explains why it remains a matter of private negotiation and is a useful lesson in how financial regulation is actually made and broken

The Securities and Exchange Commission adopted the Private Fund Advisor Rules in August 2023 after a lengthy and much-discussed rulemaking. The package went well beyond side letters. It required quarterly disclosures showing fees and expenses required secondary opinions on the fairness of transactions conducted by periodic advisors restricted charging investors for certain regulatory examination and compliance costs and most relevant in this case prohibited granting refunds.preferential terms or information rights when they would materially harm other investors while requiring that all preferential terms be disclosed to all investors

A coalition of industry associations including groups representing private equity managers hedge funds and venture capital filed a challenge with the Fifth Circuit Court of Appeals. Their argument was not primarily that the rules were bad policy. It was jurisdictional: that the statutory provisions the Commission relied on particularly the sections of the Advisers Act added by Dodd-Frank did not authorize such rules for funds whose investors are sophisticated institutions rather than retail clients

In June 2024 the court accepted and voided the rules in their entirety. Not reduced not sent to further work vacated. The Commission decided not to request further review

Three things are worth highlighting about that result

The first is that the underlying issue was never decided. No court ruled that first-liquidity rights were acceptable or that the disclosure regime was unnecessary. The rules died because of the question of who had the authority to write them which means that the underlying problem described in this article is completely intact

The second is that the disclosure requirement which was the least controversial element and the one that most investors really wanted disappeared with everything else. A challenge aimed at the restrictive provisions eliminated the transparency provisions as collateral damage

The third is why regulators had any case. If side letters were purely a matter of negotiating influence among equals the question of transparency would not arise. It arises because the beneficiaries of a public pension fund are not the sophisticated party but rather the people whose retirement is affected by conditions they will never see

Where the Critique Overreaches

Side letters attract a lot of criticism that treats each distinct term as a scandal. Four reasons why this is too strong

Investors really differ. A sovereign wealth fund with a tax treaty position a public pension with legal disclosure obligations and a family office with an investment policy that excludes certain sectors need different documents. Insisting on uniform conditions would not make things fairer but would make several of those investors unable to participate at all

Anchor economies are earned rather than extracted. The investor who commits $400 million to an initial fund with no track record is taking a risk that subsequent investors do not and is providing the credibility that allows the fund to raise the rest. Paying less for it is normal business behavior and without it a good number of funds would never be launched

Co-investment exclusions are defensible. The reason MFN clauses exclude co-investment is partly because it is the most valuable term and partly because it requires genuine capacity. Co-investment means entering into a specific agreement on a manager's schedule with a real team in days rather than months. Giving the right to an investor who cannot execute it produces broken deals so the exclusion reflects capacity as much as favoritism

The genuinely dangerous term is now rare where it matters most. Preferential redemption is a serious problem in an open-ended hedge fund where investors share a common liquidity pool. In a closed-end private equity fund no one can redeem anything so the concern boils down to a question of information. Applying the criticism of hedge funds to all private funds greatly exaggerates the issue

My view is that the fee and co-investment terms are ordinary business differentiation that the liquidity and information terms are the only ones that are redistributed to investors and that the entire argument would be resolved by disclosure rather than prohibition

What This Means in Practice

For an investor the operational questions are whether an MFN right is offered what its threshold levels are what categories are divided whether the disclosure will include actual language or summaries and how long the election window is. For anyone evaluating a manager a willingness to be transparent about the side letter practice is a reasonable indicator of how he or she will handle other conflicts

And to understand the industry as a whole the useful correction is that the published terms about the funds describe a starting point. The distribution of the actual terms is broader than the documents suggest and correlates almost entirely with bargaining power

How I Would Read a Side Letter Schedule

If I were given a fund's NMF electoral calendar the order in which I would work would be almost the inverse of how the document is organized

I would find the threshold levels first before reading a single term because it determines how much of the schedule is actually available to me. Everything above the threshold is information rather than an option and reading it in any other order is a waste of time and creates the impression of protection that does not exist

I would then go straight to the exclusions as the example above shows that the excluded categories are where the value is concentrated. A schedule with terms that seem generous and a reserve for advisory and co-investment committee positions has offered me the cheap end of the deal

Third I would classify the available terms into the two groups in the previous message: things that cost the manager and things that cost other investors. Only the second category tells me anything about how the manager treats its investor base and is the one worth dwelling on

Fourth I would like to ask whether the disclosure is actual language or a summary and I would treat a summary as a negative. The difference between the refund notice period being shorter and the specific wording of that provision is the whole issue

Fifth I would like to point out how long the election period is. A short window on a long schedule delivered late is a procedural way of preserving terms without appearing to hold them back

None of this is legal or investment advice and anyone who signs one of these should have it read by a lawyer rather than a student

The Bottom Line

Side letters exist because investors in a single fund do differ in size legal status and needs and they persist because the manager has an interest in negotiating privately with each one. Most of what they contain is defensible

The arithmetic shows where the value really is not where the complaints are. On a $400 million commitment a 50 basis point fee discount is worth about $20 million over the life of the fund while a fee-free co-investment over $200 million is worth about $72 million more than three times as much and is precisely the term set by most-favored-nation clauses. Both are paid by the manager

The terms worth examining are those that provide liquidity or differential information because they are redistributed among investors and not between the investor and the manager. The SEC's 2023 rules addressed exactly that distinction and the Fifth Circuit struck them down in June 2024 on the grounds that the agency lacked authority without ever getting to the bottom of it. Which leaves it exactly where it has always been: whether you thought to ask before signing