Side letters — what allocators ask for and what managers should concede

A fund’s economics are negotiated twice: once in the partnership agreement every investor receives, and again in the side letters most investors never see. Allocators treat fund side letter terms as ordinary infrastructure — the rider that adapts a pooled vehicle to one institution’s statutes, tax position, and policies. Managers too often treat each letter as an isolated favor. The letters are not isolated. They interact, they compound through MFN elections, and in two areas — liquidity and information — they carry regulatory consequences that survived even the death of the rule written to police them.

What allocators ask for

The institutional ask list is stable. Regulatory and tax accommodations driven by the investor’s legal status. Enhanced transparency — exposure or position reporting beyond what the fund documents promise. Management fee or carry concessions for size or a first-close commitment. Co-investment rights. Capacity rights — the option to maintain or grow an allocation. Liquidity modifications. And wrapped around it all, the most-favored-nation election: the right to see what others received and adopt it.

The allocator side’s published consensus is more restrained than managers expect. ILPA’s Principles 3.0 asks LPs to “limit the substance of side letters to essential statutory or other institution-specific requirements,” and asks GPs to fold provisions common across the majority of a fund’s side letters into the LPA itself — partly because side letter negotiation is an organizational expense, borne by the fund and subject to any agreed cap. The same document is blunt about co-investment: rights granted through side letters should be disclosed to all LPs.

The terms regulators police

Most side letter content is commercially negotiable. Two categories are not: preferential liquidity and preferential information.

The SEC’s exam staff reported in 2020 that advisers had granted select investors preferential liquidity through side letters without adequate disclosure, leaving other investors “unaware of the potential harm” if those terms were exercised — favored investors redeeming ahead of everyone else in a market dislocation. The staff framed the failures under the Advisers Act’s antifraud provisions and the adviser’s duty of loyalty, which under the Commission’s 2019 interpretation requires full and fair disclosure of all material conflicts.

In 2023 the Commission went further, adopting a preferential treatment rule that would have prohibited redemption and information terms with a material negative effect on other investors and required disclosure of all other preferential treatment to current and prospective investors. The Fifth Circuit vacated the private fund adviser rules in full in June 2024. The vacatur changed less than managers assume. Three months later, the SEC settled with Galois Capital Management, charging — alongside custody failures — that the adviser told certain investors redemptions required at least five business days’ notice before month end while allowing others to redeem on less. The penalty was $225,000, distributed to harmed investors. No preferential treatment rule was needed: an undisclosed redemption preference is a misleading statement to every investor who did not receive it.

Where the economics quietly break

The MFN election is where individual concessions become fund-level repricing. In the standard structure, each electing LP reviews a compendium of provisions granted to others and may adopt those granted to investors of equal or smaller commitments, with carve-outs for terms tied to an investor’s regulatory or tax status. Size-tiering and the carve-outs are the only brakes. A fee discount granted to one anchor does not cost the spread on one commitment — it costs that spread across every similarly sized or larger elector, for the life of the fund. The discipline is to price every concession as if every eligible elector takes it — over a fund’s life, the careful ones will.

Capacity rights compound differently: costless to grant, invisible on the financials — until several are exercised against the same finite capacity at once. A manager who has promised three institutions the right to grow has made a commitment the portfolio may not be able to honor, and the breach arrives at the worst moment: when the strategy is working.

Then there is the cost nobody prices: negotiating the letters. ILPA classifies it as an organizational expense — the fund pays — and a heavily lawyered first close can consume a meaningful share of an expense cap before a dollar is invested. ILPA’s model fund documents push in the same direction, moving the MFN process into the LPA itself rather than leaving it to bilateral letters.

Enforceability is a jurisdiction question

A side letter is only as good as the law underneath it, which differs by domicile and vehicle.

In the Cayman Islands, the Grand Court’s 2012 decision in Lansdowne v Matador set two traps that still catch investors. Where the side letter is signed by someone other than the registered shareholder — common when an institution invests through a nominee or custodian — the shareholder cannot enforce it. And a side letter cannot deliver the opposite of what the articles of association and subscription documents expressly provide; in Matador, a promised exemption from gating and suspension failed on that ground. In a Cayman corporate fund, both the fund and the shareholder of record must be parties, and the letter must not contradict the constitutional documents.

Delaware runs the other way. The LP statute gives “maximum effect to the principle of freedom of contract,” permits fiduciary duties to be expanded, restricted, or eliminated by the partnership agreement, and preserves only the implied covenant of good faith and fair dealing. In a Delaware fund the documents largely mean what they say — the live risk is not enforceability doctrine but sloppy drafting interacting with an MFN compendium nobody reconciled.

Funds marketed in the EU carry a statutory layer on top. Under AIFMD, no investor may obtain preferential treatment unless it is disclosed in the fund’s rules or instruments of incorporation, and pre-investment disclosure must describe that treatment, the types of investors who receive it, and their links to the manager. For an EU-marketed fund, a quiet side letter is not an option the directive recognizes.

Where to hold the line

The workable posture is not refusing side letters — institutional capital arrives with statutory requirements a pooled document cannot anticipate. It is a hierarchy of concession.

Concede freely: status-driven regulatory and tax accommodations, and transparency. Reporting costs operational effort, not economics, and a manager confident in the book loses little by showing it.

Price deliberately: fees, capacity, and co-investment — always through the MFN multiplier, never as a single bilateral cost, with co-investment arrangements disclosed rather than discovered.

Resist: preferential liquidity and selective information rights. These are the categories regulators have examined, charged, and — briefly — tried to prohibit outright, because they change other investors’ risk without their knowledge.

Keep the mechanics boring: the right counterparty on every signature page, no term contradicting the constitutional documents, one current compendium of everything granted, recurring provisions folded into the next fund’s LPA.

A side letter stack is a structure decision, like the fund’s domicile or its waterfall. It deserves the same engineering.

SetOne Labs pressure-tests fund terms, side letter stacks, and the economics beneath them for managers and allocators alike. To review a side letter stack in confidence, begin a conversation.

SetOne Labs provides advisory services and general information. Nothing here is legal, tax, or investment advice.