Not all investors want the same deal. Side letters are agreements between the fund (or its GP) and a specific limited partner that modify or supplement the terms of the limited partnership agreement. They exist because large or strategic LPs often have requirements that differ from the standard terms, and GPs need flexibility to accommodate those requirements without rewriting the LPA for every investor.
For emerging and mid-sized fund managers, side letters can feel like a burden. They add complexity to closings, create ongoing compliance obligations, and introduce the risk of inconsistent treatment across your investor base. But they are a standard part of fund formation, and handling them well is a mark of a professionally run fund.
What Is a Side Letter?
A side letter is a binding agreement that modifies the LPA for a specific LP. It sits alongside the LPA and subscription agreement as part of the investor's overall contractual relationship with the fund. The LPA governs all LPs equally; the side letter carves out exceptions for the LP that negotiated it.
Side letters are typically negotiated during the fundraising process, before the LP signs the subscription agreement. They are signed at closing, simultaneously with the subscription agreement. In some cases, LPs negotiate side letters at subsequent closings if they are increasing their commitment or if circumstances have changed since the initial close.
When Side Letters Get Negotiated
The timing of side letter negotiations follows the fundraising process. First-close investors often have the strongest negotiating position, because the GP needs anchor commitments to launch the fund. Subsequent-close investors may have less room to negotiate, but large commitments always carry weight regardless of timing.
As a fund manager, you should expect side letter requests from institutional LPs, pension funds, sovereign wealth funds, endowments, and fund-of-funds. Individual high-net-worth investors and family offices also request side letters, though their requests tend to focus on reporting and tax provisions rather than economic terms.
Your fund counsel should prepare a template side letter that includes provisions you are comfortable granting. Having a starting point speeds up negotiations and helps you maintain consistency across your investor base.
Common Side Letter Requests
While every LP has specific needs, side letter requests cluster around a predictable set of categories. Understanding these categories helps you prepare responses in advance and negotiate more efficiently.
Fee Reductions and Modifications
Large LPs routinely request reduced management fees, lower carried interest rates, or both. Fee breaks are typically tied to commitment size: an LP committing $50 million to a $500 million fund has more room to negotiate than one committing $5 million. Common structures include tiered fees (lower rate above a commitment threshold), fee waivers during the investment period, or modified fee bases (net invested capital instead of committed capital).
Be thoughtful about fee concessions. Every fee reduction affects your fund economics and, through MFN provisions, may extend to other LPs. Model the impact across your investor base before agreeing to a fee break.
Co-Investment Rights
Many LPs request the right to co-invest alongside the fund in individual deals, typically on a no-fee, no-carry basis. Co-investment rights range from a general right to be notified of opportunities (non-binding) to a contractual right to participate in a specified percentage of deals above a certain size. Consider how co-investment commitments affect your deal execution. If three LPs each have a contractual right to co-invest, you need a process for allocating co-investment capacity and managing the additional closing complexity.
Most Favored Nation (MFN)
MFN provisions give an LP the right to elect any side letter term granted to another LP of equal or smaller commitment size. After the final close, the GP typically circulates a summary of available MFN-eligible terms, and LPs have a defined window (usually 30 days) to make elections.
MFN provisions vary in scope. Some cover all side letter terms; others exclude specific categories such as fee arrangements, regulatory accommodations, or terms that are specific to the electing LP's legal status. The LPA should define which terms are MFN-eligible and the process for making elections.
LPAC Seat
Institutional investors often request a seat on the Limited Partner Advisory Committee. LPAC members review conflicts of interest, approve certain related-party transactions, and may have consent rights on specific matters defined in the LPA. If you receive more LPAC seat requests than you have capacity, prioritize based on commitment size, institutional profile, and the value the LP brings beyond capital (industry expertise, network, follow-on potential).
Enhanced Reporting
LPs may request reporting beyond what the LPA requires. Common requests include quarterly portfolio company updates, annual audited financials delivered by a specific date, ESG reporting, diversity metrics, carbon footprint data, or customized reports that match the LP's internal templates. Before agreeing, confirm that your fund administrator can produce the requested reports and that the cost is manageable. Reporting commitments accumulate quickly across a dozen side letters.
Excuse and Exclusion Rights
Some LPs cannot invest in certain sectors, geographies, or deal types due to their own investment policies, regulatory constraints, or public mandates. Excuse rights allow the LP to opt out of specific investments without being in default. Common exclusions involve tobacco, firearms, gambling, or investments in specific jurisdictions. The operational burden falls on you: you need to notify the LP before each investment and manage the capital call adjustments when an LP exercises an excuse right.
Tax and Regulatory Provisions
Tax-exempt investors (pension funds, endowments) need protections against unrelated business taxable income (UBTI) and may request that the fund structure investments to minimize UBTI exposure. Non-U.S. investors may request protections against effectively connected income (ECI). Government pension plans often need the GP to represent that the fund will not engage in activities that could cause the plan to violate state or local law. These provisions are typically straightforward to grant but require your fund counsel and tax advisor to confirm that the fund's investment program can accommodate them.
Evaluating Side Letter Requests
Not every request deserves the same response. Use a structured approach to evaluate incoming requests and decide what to grant, what to modify, and what to decline.
Impact on Fund Economics
Will this provision reduce your revenue, increase your costs, or create obligations that scale with the number of LPs who elect it through MFN? Fee reductions and co-investment rights fall into this category. Model the worst case: if every MFN-eligible LP elects this term, what happens to your fund economics?
Operational Burden
Enhanced reporting, excuse rights, and custom distribution schedules all create ongoing work. A provision that looks simple to grant may cost significant time and money to administer over a 10-year fund life. Consult your fund administrator before agreeing to operational commitments.
Precedent Effect
Will granting this term set an expectation for future funds or future LPs in this fund? If you give a 50-basis-point fee reduction to a $20 million LP, larger LPs will expect the same or better. Be deliberate about the precedents you set, especially in Fund I.
Legal and Regulatory Risk
Some requests introduce legal complexity or regulatory risk. Excuse rights may affect your fund's ability to deploy capital efficiently. Transparency provisions may conflict with portfolio company confidentiality agreements. Have your fund counsel review any provision that creates a new obligation or constraint.
Managing Side Letters Over the Fund's Life
Negotiating side letters is only the beginning. You need to track and comply with every provision across every investor for the full term of the fund.
- Build a side letter matrix. Create a single document or spreadsheet that maps every side letter provision to the LP that holds it. Include the specific terms, any conditions, and the compliance requirements. Update this matrix after every closing and after every MFN election.
- Integrate with fund operations. Your fund administrator, compliance team, and investor relations team all need to know about relevant side letter provisions. Fee reductions need to be reflected in capital call and distribution calculations. Reporting obligations need to be added to the reporting calendar. Excuse rights need to be checked before every capital call.
- Monitor MFN elections. After the final close, manage the MFN election process. Prepare the disclosure summary, distribute it to eligible LPs, track elections, and update your side letter matrix with newly elected terms.
- Review before each major event. Before capital calls, distributions, LP transfers, fund extensions, and annual reporting cycles, review the side letter matrix for applicable provisions. Missing a side letter obligation is an operational failure that can damage LP relationships and, in serious cases, create legal liability.
For a broader view of fund investment documents beyond side letters, see our Reviewing Investment Documents: A Guide for Fund Managers guide.
This article is for informational purposes only and does not constitute legal, tax, or investment advice. The content reflects general principles and may not apply to your specific situation. Consult qualified legal and financial advisors before negotiating side letters or making decisions about fund terms. Capital Company provides fund administration and operational support services; we do not provide legal or investment advisory services.