By Stuart Pinnington, Global Head of Asset Owners
Over recent years, side letters have moved from the margins of the fundraising process to the centre of many negotiations. While they were once viewed as a tool used primarily by large institutional investors, today family offices are just as active – and just as able – to negotiate bespoke terms that reflect their policies, governance preferences and liquidity needs.
In a slower fundraising market, where managers are taking longer to reach a close, both institutional LPs and family offices have increased leverage to ask for terms that align with their mandates.
Cornerstone investors, such as sovereign wealth funds, are often able to push furthest on economics and governance terms. The influence of these investors, through the size and timing of their commitment, means they’re able to use side letters to secure fee discounts, co-investment rights and governance protections.
Large institutions such as public pension schemes and global insurance groups may also have regulatory, ESG and reporting requirements that often cannot be relaxed, so managers wanting access to this capital must accommodate those terms somewhere, and side letters are the natural place to do so.
But with each additional clause carrying legal, operational and governance implications for the fund, investors need clarity on what to prioritise, what is realistic, and where bespoke terms may create challenges down the line.
Liquidity provisions
Despite side letters traditionally being seen as the territory of big players, we’re now seeing many more family offices actively taking advantage of them. Whereas larger investors typically focus on reducing management fees, family offices tend to be more concerned about liquidity.
Smaller investors are often reticent to be locked in, so their focus is typically on liquidity features, transfer rights and exit flexibility rather than headline fee breaks.
As a result, one feature that has become more common is the hybrid fund model. This includes a core strategy such as private equity or real estate combined with a liquidity component allocated to publicly listed securities. Typically, the listed securities will be in the same sector as the core strategy, so in a real estate fund this might be listed REITs. The liquidity component can be as much as 20% of the total fund allocation.
Another approach to ensure an exit strategy has been to create a pool of investors willing to acquire fund stakes in the secondary market. Sometimes, the GP will agree to buy back the stake subject to annual caps or other limits.
We’ve seen many more negotiated terms and many more bespoke structuring transactions of funds for specific investors. GPs are having to structure in a way to attract investors.
‘Most-favoured nation’ clauses
This means that the structure and tone of a side letter negotiation are shaped primarily by the type of investor and how critical their capital is to the fund. It’s therefore essential that LPs go into negotiations knowing not just what they want in the side letter, but how their position and that of their fellow investors may affect what they’re likely to get.
Many investors use most-favoured nation (MFN) clauses as a safety net in this process. MFNs typically give eligible LPs the right to use terms granted to equally sized or smaller investors, creating a degree of parity between parties. However, they do not automatically extend to every bespoke promise made to another LP.
Our recent whitepaper, produced in collaboration with Kirkland & Ellis, notes that MFNs also contribute to a proliferation of side letter provisions that must be tracked, and every exclusion or bespoke report nudges how the fund is run for everyone else. MFNs can spread benefits, but unequal economics and heavily tailored terms will quickly create friction if they look like a privilege rather than a fair reflection of an LP’s contribution.
That friction does not just live in the side letter itself; it will show up in the plumbing. Most fund administration is built around the LPA, but side letters effectively override those terms for specific investors. NAV calculations, fee rates, carry, excusals and reporting can all work differently for one LP compared to the rest. If those exceptions are not captured in systems, managers risk misbilling or misallocating returns.
Monitoring agreements
It’s therefore not enough for LPs to insist on specific terms; they should ask how those obligations are logged, monitored and tested in practice. This includes who can see which provisions, and how confidential information is protected.
One recurring problem is “leakage” between LPs in a small market, leading to others getting wind of the agreements that a peer has negotiated and demanding the same treatment. Robust operational discipline is what stands between bespoke alignment and an unmanageable patchwork of obligations.
Side letters are now central to how many funds are raised, but more leverage does not automatically mean better outcomes for investors. The most effective LPs approach negotiations with a clear sense of their own importance to the fund, an understanding of what is genuinely standard, and realistic expectations of what MFNs can and cannot deliver. Rather than pursuing a long wish list, these investors concentrate on a small set of clauses that align the fund with their mandate without distorting economics or adding unmanageable operational strain for the manager.
Therefore, LPs should be certain not just of what they want to ask for, but how their requests will shape the fund they’ll eventually invest in.
Contact us for side letter support
At IQ-EQ, we’re well versed in the enhanced administrative and reporting requirements involved in utilising side letters. If you’d like to discuss any of the insights contained within our guide or find out more about the support we could offer your firm or family office, please don’t hesitate to get in touch.
