By Justin Partington, Global Head of Fund and Asset Managers
In an environment defined by competitive fundraising, side letters have evolved into a core feature of private funds. Limited partners (LPs) are now armed with greater negotiating power and are using side letters to secure bespoke arrangements such as better economic terms or tailored reporting, among many other requests.
According to ILPA, over half of LPs and nearly 70% of large LPs report having greater negotiating leverage on side letter terms compared to a year ago. For general partners (GPs), this growing customisation of contractual terms with investors can bring fresh operational challenges.
As noted in our new whitepaper on side letters, such terms can have a fundamental impact on the administration of a fund’s operations with potential implications for the fund structure itself.
Multiple and competing side letter arrangements within the same fund increase the risk of error while add to compliance and manager burdens. Handling these documents requires an ordered, cross-functional process.
Below are five key considerations for navigating side letter negotiations effectively to reduce risk and improve efficiency while maintaining investor confidence.
1. Governance and tracking processes
The rise of bespoke LP agreements has increased the compliance and operational burden for fund CFOs and COOs. The administration involved in tracking is quite extensive, with some managers running funds with hundreds of different side letter terms.
Each side letter carries legally binding obligations varying from ESG exclusions (primarily among European LPs) to reporting obligations. The more obligations, the greater the risk that conflicting terms create material exposure or delay if not properly monitored.
Establishing a side letter workflow system that incorporates legal, compliance, tax and investor relations teams is essential. This can be supported by regular audits to ensure obligations are up to date and timely. A best practice workflow can also make a positive impression on LPs.
2. Standardised terms
GPs should seek to standardise side-letter terms as much as possible.
Incorporating frequently requested clauses such as Most Favoured Nation provisions, tax-related undertakings, and standard reporting commitments into a template side letter and fund documentation can help forestall lengthy LP negotiations. Taking the initiative to present side letter terms also signals a disciplined governance approach to prospective investors.
Standardised terms should be reviewed periodically to ensure they are in line with industry norms and that no contradictory or outdated terms are presented to LPs.
3. Carried interest arrangements
Carried interest arrangements remain one of the most negotiated side letter areas. Smaller carry-sharing percentages or smaller management-fee percentages are increasingly common.
GPs should be aware that variations in carried interest levels between investors can alter the fund structure and may require different modes of accounting for different LPs. In particular, GPs should understand how varying fee arrangements impact the waterfall model, with parallel models needed to track distributions and calculations within each step of the waterfall.
4. Safeguarding strategy and governance
Side letters often document regulatory stipulations and European LPs are increasingly using side letters for ESG or DE&I-related exclusions – all of which are important for investor alignment but are also potentially disruptive if drafted too broadly. Our whitepaper, produced in collaboration with Kirkland & Ellis LLP, warns that “any tailored LP-by-LP or deal-by-deal provisions add to a fund’s operational complexity.” GPs should ensure that all side letter terms are realistic, measurable and aligned with their overall fund strategy and capacities.
Over-promising or rescinding terms that compromise the fund’s integrity can threaten investment execution or fairness across the investor base. LP opt-out rights should therefore be drafted narrowly and be specific to the fund in question to ensure governance remains intact.
5. Investment in infrastructure and automation
Despite the rising complexity of side letter arrangements, many GPs are not fully utilising the latest technology tools and platforms. Many mechanisms used are still a bit manual, whereas it should be an automated process.
GPs should review their administrative capabilities for managing side letters to ensure they have best-in-class systems in place. Modern investor portal and document-processing tools can monitor obligations automatically, reducing the risk of human error while assisting in auditability.
Administrative systems, often deployed through third-party administrators such as IQ-EQ, now integrate dual authentication, workflow alerts and real time dashboards. While AI adoption is still in the early stages, automation is already improving data accuracy and speed.
In summary
As LPs become more sophisticated and assertive, side letters will remain central to private fund fundraising. The opportunity for GPs lies in using them strategically and offering flexibility that still aligns with fund governance. By standardising repeat clauses, strengthening governance and investing in scalable automated technology, managers can improve the efficacy of side letter management, taking it from an administrative burden to an operational advantage.
For further guidance on side letters, download our whitepaper today.
