Funds

Side Letter

A side letter is a separate agreement between an investor and a private fund, its general partner or its adviser that gives the investor different or preferential terms from the fund's governing documents. Investors commonly negotiate them at or around subscription. They typically deal with the investor's own regulatory constraints, or with commercial points such as liquidity, reporting and co-investment. For compliance teams, a side letter forms part of the investor's contractual terms, so it can change what the fund has to do for that investor and what others must be told.

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The SEC described side letters in its 2023 private fund adviser release as "generally agreements among the investor, general partner, adviser, and/or the private fund that provide the investor with different or preferential terms than those set forth in the fund's governing documents". It said they generally grant more favorable rights and privileges to certain preferred investors, such as seed investors and those with large commitments, or to investors subject to government regulation. ILPA's Principles 3.0 include side letters among fund formation documents, alongside the limited partnership agreement (LPA) and subscription documents.

What side letters typically cover

The list below combines terms mentioned in the SEC release and ILPA's Principles with common fund practice. The right-hand column gives our view of why each matters.

Type of term	Example	Why compliance or operations should care
Regulatory accommodation	Terms for an investor subject to government regulation, such as ERISA, BHCA or public records laws (examples given by the SEC)	Limits or adds to what the fund may do or disclose, and may affect reporting
Liquidity	Different redemption rights or notice	The SFC Code asks for disclosure of material redemption terms in side letters. For full-scope UK AIFMs, FCA FUND 3.2.2R requires disclosure of redemption arrangements and of preferential treatment
Information	Additional reporting on portfolio holdings or exposures, or ESG reporting	Fair treatment and selective disclosure questions
Co-investment	A right to evaluate or take part pro rata in co-investments	ILPA says GPs should disclose the existence of such arrangements to all LPs
Most favoured nation (MFN)	A right to rights or benefits equal to or better than those of certain other investors, subject to exceptions	One letter can spread to others, so the register must track who elected what
Excuse rights	A right not to take part in certain investments	Changes capital call amounts and the expected flow of money from that LP
Transfers and affiliates	Pre-agreed ability to move an interest, for example to an affiliate	Each new holder is a new KYC, beneficial-ownership and screening event
Confidentiality	Limits on disclosing the investor's identity or information	Should leave room for lawful disclosure to regulators, financial intelligence units, administrators and banks

How MFN clauses work

In the SEC's description, in an MFN clause an adviser or its related person generally agrees to provide an investor with contractual rights or benefits equal to or better than those given to certain other investors, subject to certain exceptions. The SEC said closed-end fund investors are typically entitled to elect these after the fundraising period ends, and open-end fund investors after the closing of their investment. As common practice rather than a rule, the manager of a closed-end fund often circulates a compendium of side letter terms after final closing, and eligible investors elect from it. Exceptions and size tiers are set by the contract, so check each one. Tracking those elections is an operations task, and in our view a missed one could breach the contract.

What regulators require

United States. In August 2023 the SEC adopted a preferential treatment rule (17 CFR 275.211(h)(2)-3; 88 FR 63206) that would have restricted some redemption and portfolio information terms and required disclosure of others. On 5 June 2024 the Fifth Circuit vacated the Final Rule in full in National Association of Private Fund Managers v. SEC, No. 23-60471, holding that the SEC had exceeded its statutory authority. That rule therefore does not apply. The general antifraud provisions of section 206 of the Advisers Act (15 USC 80b-6) remain, but in its section 206(4) analysis the court said a failure to disclose is not deceptive without a duty to disclose, and that the duty runs to the client, which is the fund, not its investors. Whether an undisclosed term creates exposure depends on the facts and other law, so take legal advice.
European Union. Article 12(1) of the AIFMD says no investor in an AIF shall obtain preferential treatment unless it is disclosed in the AIF's rules or instruments of incorporation. Article 23(1)(j) requires disclosure to investors of how fair treatment is ensured and, whenever an investor obtains preferential treatment or a right to it, a description of the treatment, the type of investors and any legal or economic links with the AIF or AIFM.
United Kingdom. For a full-scope UK AIFM, FCA rule FUND 3.2.2R(10) and (11) carries similar disclosure items: how the AIFM ensures fair treatment and, whenever an investor obtains preferential treatment or the right to it, a description of the treatment, the type of investors and any legal or economic links.
Hong Kong. A note to paragraph 3.14.2 (liquidity management) of the SFC's Fund Manager Code of Conduct says that where a Fund Manager has granted preferential treatment (for example, side letters) to certain investors, it should disclose that fact and the material terms in relation to redemption in the side letters to all relevant potential and existing fund investors.

Industry view. ILPA's Principles 3.0 suggest GPs include provisions common to most side letters in the LPA itself, treat negotiating costs as an organisational expense subject to any agreed cap, and disclose to all LPs the existence of co-investment rights granted by side letter.

Side letters, KYC and AML

A side letter is not a route around AML duties. Where AML rules apply, those duties bind the regulated fund, manager or administrator by law, and in our view a private agreement with an investor cannot reduce them. In our view, compliance should review side letters before signing, for these points:

Transfers. A pre-agreed right to transfer to an affiliate should stay subject to KYC, beneficial-ownership checks and screening on the new holder.
Confidentiality. Carve out disclosure required by law, and to regulators, financial intelligence units, administrators and banks. Check how the clause fits with confidentiality duties and tipping-off rules on suspicious activity.
Limits on documents. A promise not to ask for certain documents or to accept a confirmation in place of evidence needs a legal basis. See third-party reliance and the nominee and fund of funds routes.
Compulsory actions. Keep the fund's rights to refuse or suspend payments, redemptions or transfers where the law requires it.
Risk signals. Unusual terms, such as secrecy beyond normal institutional practice or an unexplained change of payer, deserve the same questions you would ask anywhere else in know-your-investor work.

We suggest keeping a central register of every letter, its parties, each operative term, the MFN elections and the owner of each obligation. Our guides to fund subscription documents and the LP onboarding checklist show where this fits in closing.

Key points

A side letter gives one investor different or preferential terms from the fund's governing documents
The SEC's 2023 preferential treatment rule was vacated by the Fifth Circuit on 5 June 2024
AIFMD, FCA rules and the SFC's Code all contain disclosure expectations for preferential treatment
In our view a side letter does not reduce the regulated firm's AML obligations, so compliance should review transfer, confidentiality and document terms

How One Constellation helps

One Constellation gives fund managers, administrators and transfer agents an investor onboarding portal with identity verification, KYB and beneficial-owner records, sanctions, PEP and adverse-media screening, transaction monitoring, and case management with STR and SAR workflows. When a side letter leads to a transfer or a new holder, teams can run the same checks on that person.

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Frequently asked

What is a side letter in a private fund?+

It is a separate agreement between an investor and the fund, its general partner or its adviser that gives the investor different or preferential terms from those in the fund's governing documents. Typical subjects include the investor's regulatory constraints, liquidity, reporting, co-investment and most favoured nation rights.

Are side letters legal?+

In our view generally yes, but disclosure and fair treatment rules can apply. In the EU, the AIFMD says preferential treatment must be disclosed in the AIF's rules or instruments of incorporation. The FCA (for full-scope UK AIFMs) and the SFC also have disclosure rules or expectations. In the US, the SEC's specific rule was vacated in June 2024, and the general antifraud provisions remain. Take legal advice on your fund.

What is an MFN clause in a side letter?+

A most favoured nation clause gives an investor rights or benefits equal to or better than those given to certain other investors, subject to exceptions. As common practice, closed-end fund investors elect from a list of terms after final closing, within limits set by the contract, such as commitment size.

Did the SEC ban side letters?+

No. The 2023 rule would have prohibited certain preferential redemption and portfolio information terms that an adviser reasonably expected to have a material negative effect on other investors, with exceptions, and required disclosure of other preferential treatment. The Fifth Circuit vacated the entire rule on 5 June 2024.

Can a side letter waive KYC requirements?+

In our view, no. AML duties bind the regulated firm by law, so a private agreement cannot remove them. A letter may record how evidence is provided, such as through a qualifying route under the applicable rules, but it should keep the firm's rights to request information and to act where the law requires it.

Sources

This entry is general information, not legal advice. Check the current text with the regulator before relying on it. Sources read on 6 November 2026.

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