Updated · Part of the CRE investment glossary
How a side letter works
Every investor in a fund or syndication signs the same core documents: the subscription agreement and the operating or limited partnership agreement. A side letter sits next to them. It is signed by the general partner or manager, on behalf of the fund, and one investor, and it changes how the core documents apply to that investor alone.
Investors ask for side letters when they bring a large commitment, arrive early, or have rules of their own to follow. A pension plan may need specific reports for its board; a family office may want a lower fee in exchange for a larger check; a foreign or tax-exempt investor may need tax-related undertakings. The sponsor agrees to what it can deliver, and the letter becomes part of that investor’s contract.
What side letters commonly cover
The terms vary by investor, but most fall into a few groups:
- Economics: a reduced management or asset management fee, a lower promote, or fee breaks tied to commitment size.
- Information: extra or faster reporting, access to the sponsor’s team, or specific data for the investor’s own regulators.
- Most-favoured-nation (MFN): the right to receive, or elect, terms granted to other investors in later side letters, usually limited to investors of the same or smaller size.
- Governance: a seat on the limited partner advisory committee, consent rights over conflicts, or notice of key-person events.
- Co-investment: the right to be offered a share of deals alongside the fund.
- Excuse and transfer rights: the right to sit out investments the investor cannot hold, or to transfer to an affiliate.
Worked example: what a fee side letter costs the deal
A fund charges a 1.5% annual asset management fee on invested equity. One investor commits $5,000,000 and negotiates 1.25% in a side letter. The rates are an example, not a market figure.
The discount is 0.25% × $5,000,000 = $12,500 a year, every year the capital is invested. If the letter has an MFN clause and a later investor of equal size gets 1.0%, the first investor can elect that rate too, and the cost doubles. That is why every side letter term has to be tracked through every fee calculation and distribution, not only at closing.
| Terms | Annual fee | Saving to the investor |
|---|---|---|
| Standard: 1.5% × $5,000,000 | $75,000 | — |
| Side letter: 1.25% × $5,000,000 | $62,500 | $12,500 |
| After an MFN election to 1.0% × $5,000,000 | $50,000 | $25,000 |
The SEC rules: what was adopted, what was vacated
On August 23, 2023, the SEC adopted private fund adviser rules that included a preferential treatment rule. As the SEC’s compliance guide describes it, the rule would have prohibited private fund advisers from granting preferential redemption rights or portfolio information that the adviser reasonably expects would have a material, negative effect on other investors, and required written notice of other preferential treatment to prospective and current investors. The guide says it applied to treatment granted "through various means, including written side letters."
On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit vacated those rules in National Association of Private Fund Managers v. SEC, and the SEC’s page now carries that notice. The preferential treatment rule is not in effect.
The antifraud rules still are. Rule 206(4)-8 under the Investment Advisers Act makes it fraudulent for an adviser to a pooled investment vehicle to make an untrue statement of a material fact, or to omit a material fact, to any investor or prospective investor. Rule 10b-5 applies the same standard to the purchase or sale of any security. Whether a side letter term is material to other investors, and how to disclose it, is a question for your counsel; this page is not legal advice.
Running side letters after closing
A side letter is easy to sign and easy to forget. Sponsors who keep their promises track:
- A register of every side letter, investor, term and effective date, kept with the investor’s record.
- Fee and distribution terms applied in the calculation itself, so a discount is never a manual adjustment.
- MFN elections: after the final close, a compendium of terms offered to eligible investors, and their elections.
- Reporting and notice duties with owners and due dates.
- Disclosure in the offering documents that side letters may be granted, in the wording counsel approves.
Primary sources
General information, not legal, tax or investment advice. Your operating agreement, offering documents, counsel and CPA govern your deal.