Using Side Letters Strategically: Legal Best Practices for Private Fund Managers
Side letters are a powerful and flexible tool in private fund formation, allowing fund managers to tailor specific terms to individual investors without amending the main limited partnership agreement (LPA). However, misusing or poorly managing side letters can expose a fund to serious legal, compliance, and operational risks. In today’s regulatory climate, institutional LPs and the SEC expect transparency, consistency, and robust governance around side letter practices.
This article outlines the legal best practices fund managers should follow to use side letters effectively and strategically while minimizing risk.
What Is a Side Letter in Private Funds?
A side letter is a supplemental agreement between a fund and a specific Limited Partner (LP) that modifies or clarifies the fund’s terms for that LP. Side letters are commonly used in venture capital, private equity, real estate, and hedge fund structures.
Typical provisions include:
Management fee reductions
Most-favored-nation (MFN) clauses
Co-investment rights
Tax structuring accommodations
Regulatory compliance adjustments (e.g., ERISA or sovereign immunity)
Why Side Letters Matter for Fund Managers
Customized Investor Onboarding: Attract anchor or strategic LPs with bespoke terms
Maintain Flexibility: Adjust fund terms without formally amending the LPA
Respond to LP Needs: Address tax, regulatory, or operational concerns
Enhance Fundraising Competitiveness: Meet institutional investor requirements
Legal and Regulatory Considerations
1. Enforceability and Consistency with Core Documents
A side letter must:
Be governed by the same law as the LPA
Reference the correct fund entity and date
Not conflict with the LPA, private placement memorandum (PPM), or subscription agreement
2. Most-Favored-Nation (MFN) Clauses
MFN clauses entitle certain LPs to elect matching terms granted to other investors, subject to commitment size thresholds.
Best Practices:
Maintain a comprehensive matrix of all side letter provisions
Use tiered MFN disclosures based on commitment size
Clearly exclude non-economic or regulatory terms from MFN elections
3. Disclosure and LPAC Oversight
Failure to disclose material side letter terms may breach fiduciary duties and lead to LP disputes.
Compliance Tip:
Share key side letter terms with the LP Advisory Committee (LPAC)
Include disclosures in annual reports and audits
4. Regulatory Compliance and SEC Scrutiny
The SEC’s 2023 Private Fund Adviser Rules increase transparency requirements:
Preferential treatment (e.g., liquidity rights or reporting access) must be disclosed to all LPs
Conflicts must be mitigated or disclosed in Form ADV and fund documents
Operational and Governance Risks
Inconsistent Terms Across LPs: Can lead to conflicts, especially during fund restructuring or extensions
Administrative Complexity: Tracking and complying with numerous bespoke terms
Recordkeeping Failures: Inadequate documentation can result in audit issues or regulatory violations
Best Practices for Drafting and Managing Side Letters
Use standardized templates reviewed by legal counsel
Avoid open-ended obligations or uncapped liabilities
Include clear expiration or renewal terms for special rights
Maintain a digital compliance system to track all executed side letters across funds
When Are Side Letters Most Common?
Commitments from anchor investors or fund-of-funds
Foreign or tax-exempt LPs needing jurisdictional structuring
Strategic or corporate LPs negotiating for board observer or data access rights
Transparency, Governance, and Legal Precision
Side letters are indispensable for customizing fund relationships, but they must be deployed with legal discipline and regulatory foresight. Fund managers should adopt standardized processes, align all agreements with the LPA, and proactively manage disclosure and compliance to avoid legal exposure.
For legal review or strategic development of side letter policies, contact our private fund advisory team at 786.461.1617 to schedule a consultation and strengthen your fund's legal infrastructure.