Back to Basics | Most favoured nations ("MFN")

Published in May 2021

In brief

• The MFN process allows investors to elect – and sometimes review – the terms of other investors’ side letters. For our Back to Basics briefing on side letters please click here.
• The MFN process has become a fixed feature of most private funds in recent years as investors seek to improve the terms of their investment.
• The inclusion of an MFN provision, in either an investor’s side letter or the fund’s constitutional document, should be carefully considered by both investors and sponsors alike.
• Accommodating the MFN process places additional financial, administrative and disclosure burdens on sponsors, particularly in open-ended products.
• To limit these burdens, the MFN process is typically subject to certain carve-outs or restrictions.
• The proliferation of investor side letter requests in recent years means that the MFN process is more important than ever.

What is MFN?

Almost all investors in private funds now request specific terms relating to their investment and these are usually documented by way of side letter. With so many investors now benefitting from specific side letter terms, fund sponsors have sought to regularise investors’ rights in an even-handed manner by way of a most favoured nation (“MFN”) provision, which is now commonplace in fund documents or side letters.

In a nutshell, a MFN provision typically entitles an investor to elect the benefit of rights contained in other investors’ side letters and potentially also the right to view the other investors’ side letters, with the premise being that certain investors should not be afforded special or additional rights arbitrarily.

Carve-outs

Whilst ensuring an even-handed approach to side letter rights, fund sponsors often look to avoid a “free-for-all” on side letter rights, and also afford larger, first close or repeat investors more favourable rights, by providing certain exceptions to rights electable under the MFN process. This is achieved by introducing MFN carve-outs, which qualify or completely restrict an investor’s right to elect provisions contained in other investors’ side letters.

Some common carve-outs include:

• Tiering: the right to elect a provision from another investor’s side letter is linked to the size of an investor’s investment in the fund. The effect of tiering is that smaller investors are precluded from electing the side letter provisions of larger investors.
•  LPAC / Investor Committee: investors may be precluded from electing a provision which permits the investor to appoint a representative to the Limited Partnership Advisory Committee (“LPAC”). The LPAC is formed for the purpose of consulting with the sponsor or general partner on specific issues during the lifetime of the fund and the right to appoint a representative to the LPAC may be reserved for larger or first close investors.
• Legal, Tax and Regulatory: Certain investors in the fund may be subject to legal, tax and regulatory requirements by reason of their specific individual circumstances. For example, a German domiciled investor is likely to be subject to reporting requirements to BaFin, the German financial regulatory authority. Consequently, it is likely that the German investor’s side letter will contain provisions that grant it rights to certain information from the fund sponsor in order to fulfil these reporting requirements. A non-German domiciled investor may therefore be precluded from electing this provision.
• Fees: Larger or first close investors may, for example, be afforded special management fee discounts by virtue of their ticket size or early support for the fund. These discounts may not apply to small investors or those investing at later closings.

Practical implications of MFN

With MFN is now commonplace in the private funds world, sponsors and investors alike should be alive to its implications. Some examples of these are set out below.

Implications for GP/Sponsors

• Compliance Costs:
  • Institutional investors in particular are likely to have a long list of side letter provisions, acceptance of which is contingent on their investment. These typically involve additional compliance and reporting burdens, the cost of which may borne by the fund, thus impacting its returns. Consequently, sponsors will often look to push the cost of compliance onto the investor requesting it. MFN inevitably means that these costs multiply as other investors elect such provisions.
• Administrative Burden:
  • Throughout the life of the fund, the manager will have to ensure compliance with all rights elected under the MFN provisions, and without appropriate MFN carve-outs the sponsor may inadvertently create a cottage industry of compliance obligations. Adopting standardised language and an appropriate set of MFN carve-outs can ease the administrative burden.

Implications for Investors

• Affirmative Investor Action:
  • Investors should be aware that sponsors will often require MFN elections to be submitted within a certain period following closing. Late MFN election submissions are at risk of being rejected by the fund manager.
• Disclosure and Transparency:
  • Sponsors may seek to limit their disclosure obligations in the MFN process. Sponsors may choose to only disclose the general terms or a summary of other investors’ terms, without fully disclosing the specifics. Investors may wish to insist on full disclosure obligations on the part of the sponsor.
• Consistency:
  • If a MFN clause is contained within an investor’s side letter and not the fund’s constitutional document, investors should be mindful that the drafting of the MFN clause may be different from that contained within other investors’ side letters (which may not be visible to the investor at the point of investment). This creates a potentially opaque and complex system of rights governing the MFN process where certain investors may be given preferential MFN rights in addition to preferential side letter provisions.

Open-ended vs. closed-ended funds

Side letters and the MFN election process have historically been a feature of closed-ended investment funds. However, the process has in recent years more prevalent in open-ended funds as a greater volume of institutional capital flows into open ended products and such investors look to standardise the terms on which they invest across both open and closed ended products.

The concerns noted above should be approached even more carefully by sponsors of open-ended funds as a perpetual life brings the risk of indefinite compliance burdens, and the continuous offering process may be hamstrung by rights offered to earlier investors. Where closings on open-ended products are anticipated frequently, sponsors may even wish to avoid an MFN provision altogether or restrict MFN provisions to fees, redemptions and other essential rights, so as to avoid running a burdensome MFN election process following each closing.