Introduction
In the private credit space, side letters remain crucial for tailoring fund terms to the regulatory, tax, operational and policy needs of investors. They are a key feature of private credit fund negotiations, with investors routinely presenting extensive lists of bespoke requirements. The proliferation of preferential terms has turned side letter management into a core governance issue for fund managers. This is particularly acute in private credit funds where the volume of underlying investments and the managers’ more limited access to portfolio companies’ information (relative to controlling equity sponsors) can amplify the operational challenges of complying with bespoke side letter commitments. In the current environment, marked by heightened investor scrutiny and evolving regulatory expectations, the primary areas of focus include enforceability, MFN (most favored nation) design and operational feasibility.
Enforceability and key terms
A side letter is a binding agreement between the fund and a single investor, which supplements but cannot alter the fund documents or create inconsistent third‑party rights. Priority language is typically used (e.g., confirming that the side letter prevails with respect to that investor without altering others’ rights) and certain provisions may trigger formal amendments to the fund documents (e.g., additional investment restrictions) or manager policies to ensure regulatory compliance.
In private credit funds, the most frequently requested preferential terms relate to economics, investment limitations/excuse rights, transfer rights and information/reporting obligations. Investors tend to seek bespoke fee arrangements such as management fee deals, carry adjustments and potentially other fee sharing or offset arrangements. They typically also require affiliate transfer and excuse/opt‑out rights to accommodate regulatory or internal policy constraints that prohibit exposure to certain types of investments. Enhanced reporting and information rights are likewise common, investors increasingly requiring granular portfolio and valuation data to meet their own compliance and reporting obligations, including under frameworks such as Solvency II and the Sustainable Finance Disclosure Regulation. The breadth of these requests takes on particular significance in private credit, where the manager will need to assess the feasibility of complying with bespoke investment restrictions, notification obligations or reporting requirements across a substantially larger number of individual investments than would typically be the case in a private equity fund.
MFN mechanics
Investors continue to expect transparency around preferential terms. This expectation is reinforced by the regulatory framework applicable to managers subject to Directive 2011/61/EU (AIFMD), which imposes obligations to ensure the fair treatment of investors and to disclose any preferential treatment granted to investors. An MFN mechanism is often used for that purpose. It may be included in the fund’s documents (giving all investors equivalent MFN rights) or offered to certain investors via side letters. It typically requires the fund manager to (i) disclose to investors the preferential terms granted to others and (ii) allow investors to elect certain of those terms for themselves, subject to (a) certain exclusions (for example, advisory committee seats, priority co‑investment rights or investor‑specific regulatory and tax provisions) and (b) other conditions such as commitment size or a materiality threshold. The specific drafting of the MFN provision therefore requires particular attention given its interaction with the election process and fund manager operational procedures.
When it comes to the MFN election process, credit fund managers typically take one of three approaches, each balancing transparency, operational considerations and regulatory constraints. The first approach involves distributing a single MFN compendium and election form to all investors, with full disclosure of all preferential terms usually organized into three categories: (1) terms that any investor may elect if its commitment meets or exceeds that of the investor originally granted the term; (2) terms that are electable only where the investor both meets the commitment threshold and shares the same legal, tax or regulatory status or can demonstrate that it has the same internal policy requirements; and (3) terms that are not electable due to the exclusions set out in the MFN provision. The second approach also provides full disclosure but tailors the compendium and election form to each investor, the categories being the same as for the first approach except for category 1, which shows only the provisions that the specific investor can elect based on its commitment size, with provisions available to investors with larger commitments relegated to category 3. The third approach discloses, in an investor bespoke compendium and election form, only the category 1 and 2 terms that the specific investor can elect, accompanied by a statement that other preferential treatments (i.e., category 3 terms) will be disclosed upon request to the manager or available at the registered office of the fund.
From a process perspective, the first approach is the least time‑consuming but places the eligibility analysis on investors and may prompt more queries, whereas the second approach is the most operationally intensive but generally reduces investor questions, the third approach sitting between the two in terms of effort and transparency.
Operational feasibility
A sometimes-overlooked issue is whether the side letter terms negotiated during fundraising are actually deliverable in day‑to‑day operations. In the midst of investor negotiations, operational execution is not always at the forefront of the process, yet early feasibility analysis materially reduces the risk of breaches and costly re‑papering. In the private credit space, where bespoke obligations, such as reporting requirements, may need to be monitored and performed across a high volume of individual investments, often with more limited access to borrower information than an equity sponsor would have, the importance of this analysis is heightened.
An MFN matrix that maps each eligible term, commitment‑size tiers, time limits and exclusions serves a dual purpose: it provides a structured framework for managing the MFN election process and controlling which terms are electable by which investors, and it also operates as a practical reference tool enabling the manager to verify, on an ongoing basis, the specific terms agreed with each investor without the need to review individual side letters. Implementing a cross‑function sign‑off process at the point of negotiation with a documented confirmation that internal systems and third‑party providers (including the depositary/custodian, administrator or loan agent) can support any additional obligations imposed on the fund or the manager also reduces the risk of agreeing impracticable terms. An effective implementation is further supported where the final terms are translated into operational materials, such as manuals or playbooks, with clear owners, workflows and timelines, and circulated to the relevant functions responsible for implementation and oversight. Fund managers may also consider leveraging third‑party compliance platforms and legal technology tools, including AI‑driven solutions, to automate the monitoring of side letter obligations, generate periodic compliance certifications and provide systematic reminders to the relevant teams.
Conclusion
Well‑drafted fund documentation, a coherent MFN architecture and strong operational controls are essential to reduce risk, enhance investor confidence and protect fund terms.
