In an era where fund investors are increasingly critical of transparency and equality, side letters and the associated Most Favored Nations (MFN) clause play a crucial role in the private equity landscape. These supplementary agreements enable General Partners (GPs) to make tailored arrangements with specific Limited Partners (LPs). However, this can lead to preferential treatment for larger LPs, disadvantaging smaller investors. The MFN clause provides an important mechanism to ensure equality and transparency. This article explores how the MFN clause works and its necessity for managing conflicts of interest in private equity funds.

Private equity funds often rely on side letters, which offer individual LPs specific advantages that are not outlined in the standard Limited Partnership Agreement (LPA). Large institutional investors, such as pension funds, typically possess the negotiating power to secure more favorable terms, such as lower fees or co-investment opportunities. These arrangements often remain hidden from other LPs, inherently leading to conflicts of interest within the fund. The analysis by William W. Clayton in his article “Conflicts of Interests in Private Equity Funds” (Yale Journal on Regulation) highlights the risks arising from these structures. Clayton argues that larger LPs often focus on maximizing their own benefits at the expense of smaller investors’ interests. This underscores the necessity of implementing mechanisms that ensure all LPs receive equal opportunities.

The MFN clause is designed to grant LPs the right to equal treatment. When a side letter provides more favorable terms to one LP, other LPs can claim the same rights, unless specific legal or tax provisions are at play. This creates a system that promotes transparency and enforces equal treatment. The MFN clause obligates the GP to share the terms of each side letter with all LPs, ensuring there are no hidden agreements that could disadvantage certain investors. As a result, the asymmetry of information between large and small LPs is reduced, better safeguarding the interests of all investors.

Nevertheless, the MFN clause is not without its limitations. Benefits related to specific legal or tax situations are not always available to all LPs, which is understandable, as not all investors are subject to the same regulations or tax obligations. Additionally, some side letters may pertain to specific rights, such as the nomination of a representative to the Limited Partners Advisory Committee, which do not automatically extend to other LPs.

Ensuring equality among investors in private equity funds remains a challenge. However, the MFN clause offers crucial legal protection for LPs, particularly smaller investors who might otherwise be disadvantaged. Clayton’s analysis of conflicts of interest makes it clear that without these protective mechanisms, larger LPs could dominate the dynamics within the fund.

Thus, the Most Favored Nations clause is an essential instrument for managing conflicts of interest within private equity funds. It promotes transparency and ensures that all investors have access to the same benefits, regardless of their negotiating position. For funds that strive for good governance and equal treatment, the MFN clause is a cornerstone of their legal structure. Fund managers should seriously consider this clause to ensure a fair and transparent investment environment for all parties involved.