Negotiating a deal that you and your investment committee are happy with is no longer enough for many private fund investors. Instead, Fear of Missing Out is a common investor mindset, and investors often crave comfort that they have negotiated the best deal, or that any better deal given to someone else will be offered to them too.
Most Favoured Nations rights
The Most Favoured Nations (MFN) right common in most sophisticated private fund investment documents caters brilliantly for FOMO concerns. An investor with MFN rights can generally elect to receive the same benefits or rights offered to other investors, subject to certain conditions and exceptions. A common MFN condition is that an investor may only elect provisions granted to another investor who has invested the same amount or less than they have.
Side letters in private funds
Whereas in the past, side letters were typically restricted to addressing issues such as fee rebates, tax and regulatory issues specific to the particular investor (e.g. pension funds), we are now seeing side letters used as a broader negotiating tool. Typically sponsors spend months finalising their limited partnership agreements (LPAs). When negotiating with initial investors, they may be willing to amend and restate their LPAs to reflect negotiated outcomes that apply to all investors. However, once the first investors have committed to the fund on the basis of an LPA, the mood shifts, and many sponsors prefer to lock the LPA so that no further amendments are made unless absolutely necessary. This is generally because of a desire to communicate to investors that the documents are final and not subject to further negotiation, and also because amending the LPA once third party investors have become limited partners becomes more complex and may require investor approvals. Instead, when negotiating with later close investors in particular, sponsors often prefer to address relevant issues by way of side letter if possible so that the fund documents can remain unchanged.
In addition, as regulatory requirements increase world-wide (e.g. restrictions on investment of pension fund money) and institutional investors in particular develop comprehensive internal policy and other investment requirements (e.g. ESG guidelines, excuse requirements), the humble side letter has morphed into a bespoke investment arrangement for each individual investor.
The combination of highly detailed side letters, MFN rights and a FOMO mindset means that many investors will elect as much as possible during the MFN process, regardless of whether or not they truly want or need the relevant right or benefit.
3 key tips for managing the MFN process
An increase in the number of side letter provisions has a direct impact on the MFN process as there are many more provisions which may be subject to election by other investors. The process itself can be administratively difficult, costly and time consuming. Three key tips for sponsors to best manage your MFN process are:
- keep MFN rights front of mind at all times in your investor negotiations, as you may need to offer a negotiated provision to other investors, not just the investor who asked for it;
- try to conform side letter provisions during the negotiation process to simplify MFN elections. If you offer a standard provision in relation to the same matter, rather than accepting multiple variations of clauses which address the same issue albeit in slightly different ways, this will simplify the MFN election process considerably; and
- restrict MFN elections to post-final close, rather than after each closing. It is administratively easier to deal with all provisions together rather than in separate tranches.
MFN innovation - an alternative approach?
Given the above, it may well be time to question whether extensive side letters and broad MFN rights remain the best approach for investor negotiations.
Perhaps MFN rights should be limited to the one key issue that is important to all investors – fees. This could capture any rights or benefits negotiated with investors relating to issues such as fee rebates and different carry arrangements, where the sponsor did not want to disclose these to all investors in the LPA. This approach would still permit investors to negotiate provisions in their side letters which relate to their own specific circumstances (e.g. excuse rights, tax and regulatory requirements/restrictions) but would reduce the administrative pressure on sponsors to offer such provisions to other investors, even if they are subject to similar requirements. It also encourages investor responsibility for their own requirements rather than providing an assorted chocolate box of different, albeit applicable, requirements of other investors from which to choose.
Alternatively, those sponsors who can meaningfully assess their likely investor base at the point of establishment of the fund (most likely large, institutional sponsors) could seek to include a schedule of provisions to apply to certain categories of investors, and incorporate these in schedules to the LPA – for example, to deal with issues such as specific pension fund investor requirements and restrictions in different jurisdictions (e.g. Canada, Australia, Germany) or tax treatment of different types of investors from different jurisdictions. This is likely to require significant up-front preparation and cost for the sponsor (at least for their initial fund that adopts this approach), but may seek to minimise side letter requests going forward and consequently reduce the administrative burden of MFN elections. Perhaps the LPA could be drafted so that schedules addressing regulatory/tax requirements particular to a certain group of investors could be inserted as a result of investor negotiations in the fundraising process, without requiring limited partner approval, so that these would apply to similarly situated investors going forward without the need for MFN elections.
An approach which enables sponsors to meet investor requirements while reducing the MFN administrative burden on the fund must be the way forward.