- Side letter essentials for emerging managers
- What is a side letter in private funds?
- Common side letter rights and terms for fund managers
- What is a most favored nation (MFN) clause?
- What are information and reporting rights?
- Do LPs negotiate for fee discounts?
- Can LPs ask for special transfer rights?
- What are co-investment and excuse rights?
- How GPs use side letters when investing in startups
- The operational challenges of managing side letters
- A checklist for managing side letter compliance
- Frequently asked questions about side letters
- Are side letters legally enforceable?
- What is a pro-rata right in a side letter?
Side letters are essential for securing institutional capital, and they introduce significant operational complexity to your fund administration. In this article, you’ll learn about common side letter provisions and a strategy to track these bespoke obligations throughout the fund lifecycle.
What is a side letter in private funds?
A side letter is a binding agreement that grants a specific investor, known as a limited partner (LP), special rights or terms that are not available to all other investors in the fund. These agreements are confidential and tailored to the specific relationship between the fund and that investor.
You use a side letter to a primary contract like the limited partnership agreement (LPA) in order to accommodate an important LP’s unique needs. This allows you to secure their capital without having to change the rules for everyone else in the fund. It’s a standard practice in private fund investing to help close deals with institutional investors who have specific requirements.
The main fund agreement, the LPA, sets the general rules for how the fund operates. However, large institutional investors often have internal policies or regulatory requirements that the standard LPA does not cover. A side letter bridges this gap by addressing those specific requirements directly.
When you sign a side letter, you are creating a separate contract that overrides the LPA for that specific investor. This means you must track these unique obligations separately from your general fund operations. Failure to do so can lead to a breach of contract.
Common side letter rights and terms for fund managers
Now that you understand the purpose of a side letter, it’s important to recognize the common provisions you will likely encounter when fundraising. Institutional investors often have a standard set of requests they present to every fund manager after reviewing the investor pitch deck. Understanding these terms in advance helps you negotiate effectively and protect your firm's interests.
What is a most favored nation (MFN) clause?
A most favored nation (MFN) clause is a right for an LP to receive the benefit of more favorable terms subsequently granted to other investors in the same fund. It gives an LP the right to see the terms other LPs have negotiated in their own side letters. If they see a term they prefer, they can elect to receive that same treatment.
This clause ensures that an early or large investor does not end up with worse terms than a later investor. However, it creates a web of obligations that can be difficult to track manually. You must carefully manage these elections after the fund’s final close to ensure everyone gets the rights to which they are entitled.
MFN clauses are often tiered based on the size of the investment. For example, an investor who commits a small amount might not get the right to see the terms given to an investor who commits a large amount. You need to track which investors are entitled to which terms to avoid giving away too much.
What are information and reporting rights?
Information rights allow an LP to demand more frequent or detailed reports than what you provide to the rest of the fund. While standard investors might receive quarterly updates, an investor with these rights might require monthly data or specific portfolio analytics. This is often necessary for their own internal compliance or regulatory reasons.
This side letter term can create a significant administrative burden if you are not prepared. You may find yourself creating bespoke reports manually for different investors, which takes time away from deal-making. It is vital to understand exactly what data an LP needs before agreeing to these terms.
Some investors may require specific reporting on environmental, social, and governance (ESG) criteria. Others may need detailed tax information derived from the general ledger (GL) that goes beyond the standard Schedule K-1. You must assess whether your back office has the capacity to generate these reports on a regular basis.
Do LPs negotiate for fee discounts?
While the classic 2-and-20 fee structure remains the norm, it is common for certain types of investors to negotiate for lower fees or a reduction in costs. For example, some managers of smaller venture funds may be willing to reduce their carried interest to as low as 15% as a way to attract LP interest.
Fee discounts are often granted to investors who commit a large amount of capital, such as a family office, or invest early in the fund, known as anchor or early-bird LPs. They use their leverage to lower the price of participation.
Management fee discounts: This reduces the percentage of committed capital the LP pays annually to cover your firm's overhead.
Carried interest discounts: This allows the LP to keep a larger portion of the profits generated by the fund, effectively reducing the performance fee you earn.
Can LPs ask for special transfer rights?
A transfer rights clause gives an LP more flexibility to sell or transfer their interest in the fund to another party via secondary markets (platforms where investors buy and sell existing interests in private funds). Standard fund agreements usually restrict an investor's ability to leave the fund before it winds down. This side letter provision provides an exception for specific LPs who may need liquidity sooner. Transferability is a key concern for institutional LPs with strict capital requirements.
GP-led secondaries are an increasingly popular method for achieving liquidity, with the mechanisms they employ seeing significant growth. For example, the growth of secondary markets, where LPs can sell their fund interests to third-party buyers to achieve liquidity before a fund winds down, has been gaining steam, with total transaction value climbing 68% year over year in the second quarter of 2025.
While transfer rights offer a path to liquidity for individual LPs, fund managers are increasingly using fund-level solutions to provide liquidity options to all their investors. GP-led secondaries are one of the most popular methods for achieving this.
While this benefits the LP, you as the GP need to retain control over who your investors are. You must ensure that any transfer includes the right for you to perform due diligence. You must perform know your customer (KYC) checks on any new incoming LP. Additionally, GPs typically retain the right to withhold consent for transfers to competitors or entities posing reputational risk.
GPs typically consult with legal counsel to determine appropriate grounds for withholding transfer consent, such as when a prospective investor is a competitor or poses a reputational risk. Negotiations often result in side letter language stating that consent cannot be “unreasonably withheld,” a standard that legal teams use to balance LP liquidity with GP control. Engaging legal experts early ensures that the final side letter reflects a balance between LP liquidity and GP control that all parties are comfortable with.
What are co-investment and excuse rights?
These two rights control an LP's participation in specific deals within your portfolio. They allow investors to either opt out of deals they cannot touch or double down on deals they love.
Excuse rights: These allow an LP to opt out of a specific investment if it violates their internal rules or ethical mandates. For example, a university endowment or pension fund may be prohibited from investing in tobacco, firearms, or gambling companies. LPs may also negotiate specific carve-outs for certain industries.
Co-investment rights: These give an LP the opportunity to invest additional capital directly into a portfolio company alongside the fund. This is often attractive to LPs because these direct investments, often structured via a special purpose vehicle (SPV), frequently come with reduced fees compared to the main fund.
Excuse rights require you to carefully track the nature of every investment you make. If an investment falls into a restricted category, you must exclude the relevant LPs from that deal. This affects how you call capital and calculate ownership percentages for that specific asset.
Co-investment rights can be a powerful tool for you as a fund manager. They allow you to pursue larger deals that might otherwise exceed your fund's concentration limits. However, managing the allocation process and ensuring fairness among LPs with these rights can be operationally complex.
How GPs use side letters when investing in startups
When you, as a GP, invest your fund’s capital into a startup, the roles reverse. You will use a side agreement to secure important rights for your fund from the portfolio company. These rights protect your investment and give you influence over the company's direction.
You need these rights to effectively manage your portfolio and report back to your own investors. Without them, you might not have visibility into how the startup is performing.
Pro-rata rights: This guarantees the fund an opportunity to make a follow-on investment in the startup's future financing rounds to maintain its ownership percentage. This is critical for avoiding dilution in your best-performing assets.
Information rights: This obligates the startup to provide the fund with regular financial statements and performance updates. You need this data to value your portfolio and report to your LPs.
Major investor rights: This typically includes enhanced economic rights such as pro-rata participation, rights of first refusal (ROFR), and co-sale rights. This might include decisions to sell the company, raise more debt, or change the business model.
Securing these rights often depends on the size of your check. Lead investors almost always get a side letter with these provisions. Smaller investors may have to fight harder to get them included.
The operational challenges of managing side letters
A private fund lifecycle can last a decade or longer, as it takes many years for investments to mature and generate returns for LPs. For example, it can take several years for a venture fund to begin generating distributions to paid-in capital (DPI). After five years of investing, more than 60% of VC funds from the 2019 vintage had not yet distributed any capital back to their LPs.
Relying on spreadsheets and memory to track these complex, long-term obligations is a significant operational risk. If a key team member leaves, the knowledge of these specific agreements might leave with them. A missed obligation can damage an LP relationship and your firm's reputation.
You might have dozens of side letter arrangements across multiple funds. Each letter might contain different variations of MFN clauses, reporting requirements, and fee structures. This is where a centralized system becomes essential. Carta Fund Administration is a purpose-built platform designed to solve this problem. By centralizing all fund documents and obligations, the platform turns side letter management from a manual, high-risk task into a streamlined and auditable process.
A checklist for managing side letter compliance
You can manage the complexity of side letters by following a consistent process. Frame this as a simple workflow to follow for every fund you launch. This helps ensure that no obligations are missed as your firm grows.
Establish your "house" terms: Before you start fundraising, work with your fund’s legal counsel or law firm to decide which side letter requests you are willing to grant. Create standard language and templates for these terms so you are not drafting from scratch every time. This ensures you are receiving sound legal advice before finalizing any terms.
Track every agreement: During fundraising, maintain a master log of all agreed-upon side letter terms for each LP. Do not wait until the fund closes to organize this data.
Run the MFN election process: Immediately after your final close, you must conduct the MFN election process. This involves disclosing the relevant terms to eligible LPs and documenting their choices.
Centralize and automate: Use a dedicated fund administration platform to serve as the single source of truth for all side letter obligations. This allows you to automate compliance checks and reporting where possible.
Review before wind-down: Before dissolving the fund, conduct a final review of all side letters. You must ensure every long-term obligation, including any potential waiver of specific requirements, has been fulfilled before closing the books.
Establishing house terms early saves you time and legal fees. It allows you to push back on unreasonable requests by stating that they deviate from your standard policy. It also ensures consistency across your LP base.
Tracking agreements in real-time prevents a backlog of work at the end of the fundraising period. It also allows you to see the aggregate impact of the concessions you are making. You can spot if you are giving away too much in fee discounts or creating too many reporting burdens.
The MFN election process is an essential compliance step. You must notify all eligible investors of the terms that triggered their MFN rights. You then need to record which investors chose to adopt those new terms and update your fund administration records accordingly.
Centralizing this data allows your fund administrator to act as a check on your operations. They can verify that fee calculations match the side letter terms and that capital calls respect excuse rights. This adds a layer of security to your back-office operations.
Finally, the review before wind-down ensures a clean exit. You do not want to face a lawsuit from an LP after the fund has been dissolved because you missed a final distribution requirement.
To streamline your fund closing and track these agreements from day one, request a demo of Carta Fund Management.
Frequently asked questions about side letters
Are side letters legally enforceable?
Yes, a properly drafted and executed side letter agreement is a legally binding contract. It is enforceable in court, provided it meets the standard requirements for contract formation.
What is a pro-rata right in a side letter?
A pro-rata right is a clause that allows an investor to maintain their initial ownership percentage in a portfolio company. It gives them the option to participate in subsequent funding rounds. This protects the investor from being diluted as the company issues more shares to new investors.
