A side letter that ranks one holder ahead of its class is a new class.

Side letters are ordinary, and most of them are harmless. A holder with its own regulatory requirements wants reporting in a particular form and at a particular frequency. A sovereign wants an excuse right for investments its own law forbids it to make. A pension institution wants confirmation that the manager will not do a thing its investment policy prohibits. A holder in a state with its own disclosure rules wants the fund's confirmation that it will supply what that state requires. Each is a letter between the manager and one holder, outside the constitution, and each is lawful if the constitution permits it and the other holders know it exists. A letter of a different kind is not ordinary. A reduced charge, a larger share of gain, a preferred position in the waterfall, a right to be paid first on a distribution in kind, a co-investment right on terms the other holders do not receive, a hurdle on a different base: each changes the holder's economic position relative to its class, and the constitution created classes with stated rights. The letter has created another one, unnamed, with rights the register cannot read, and a class the register cannot read is a class the register did not subscribe beside.

This note sets out the two kinds of letter and the line between them, what the constitution creates when it creates a class and why a letter cannot, the most-favoured-nation clause and its reach and exclusions, the concession schedule, the disclosure rules in the centres and the regulators' reading, what the constitution should say about letters, the administrator's position, the lender's clause, the continuation and the letters, a comparison, a worked letter as a type, cases, what each party holds, the sequence, questions, terms and what to read.

The two kinds

The first kind settles how the manager deals with a particular holder: what it reports, in what form, when; what the holder may decline to fund, for what reasons; what the manager confirms about its conduct; what the holder may disclose to its own regulator; who the holder's representative on the committee is. None of those changes what the holder receives from the fund relative to the others; each changes how the holder is served. The constitution permits them, the concession schedule records them, and the most-favoured-nation clause lets the others elect the ones that fit.

The second kind changes what the holder receives: a lower charge, a higher share of gain or a lower manager's share on its units, a hurdle on a better base or from an earlier date, a priority in the waterfall or on a distribution in kind, a co-investment right with economics the others lack, an excuse right so wide that the holder's capital is in a different portfolio. Each is an economic term, and an economic term that differs between holders is a class. The constitution creates classes; a letter purports to, and a letter that does is a class the constitution did not create, unseen by the holders who would have objected, and unenforceable in the reading most courts and regulators give to a constitution that lists its classes and a letter that adds one.

What a class is

A class is a set of units with stated rights, created by the constitution, disclosed in the memorandum, with its own terms on the charge, the share of gain, the hurdle, the waterfall's ranking, the voting and the transfer. The constitution lists the classes and the rights of each, and a holder subscribing to one class knows what the others hold. A class is created by the constitution's amendment procedure, with the consents it requires, which usually include the consent of the classes whose rights are affected. A letter bypasses all of that, and the holders of the existing classes, whose position the letter changes by creating a class ahead of them, were never asked.

The most-favoured-nation clause

Most registers protect themselves with a clause entitling each holder to elect the benefit of any term granted to another. The clause has a reach, and the reach is drafted at the first investor's negotiation, because it cannot be widened afterwards without that investor's consent. It usually excludes terms tied to the size of a commitment, so that a larger holder's better terms do not travel to a smaller one; terms tied to a holder's regulatory or tax position, so that a sovereign's excuse right does not travel to a corporate; terms tied to a holder's status as a first or anchor investor; and terms the manager grants to its own affiliates. Inside the reach, a term granted to one is granted to all who elect it, and a manager who gave one holder a better economic position has given it to the register, with the consequences for its own economics that implies. Outside the reach, the term stands, and the other holders have the disclosure and nothing else.

Why letters drift into economics

Letters drift into economics because the placement team closes holders one at a time and each holder's last request is answered by the person closest to the close. A holder that wants a lower charge is told no by the constitution and yes by a letter, because the letter is a page the manager can sign tonight and the class is an amendment that needs the existing holders' consent next month. The letter closes the holder and opens a class the manager did not mean to create, and the manager discovers what it created when the most-favoured-nation elections arrive or the administrator asks how to run a waterfall the constitution does not describe. The discipline is a rule that no letter touches the charge, the share, the hurdle, the waterfall or the distribution priority, given to the placement team in writing, and a class procedure the manager is willing to run when a holder's request is worth it.

The first investor's exclusion set

The most-favoured-nation clause's exclusions are drafted once, at the first investor's negotiation, and every later holder's clause follows the first's, because a later holder that negotiated a wider reach would import the first's terms and the first would object. The exclusion set therefore decides, for the whole raise, which concessions travel: a narrow set drafted to win the first commitment makes every later concession travel to the first investor and to everyone after; a set drafted with the whole raise in view excludes the concessions the manager knows it will have to make, commitment-size classes, regulatory excuses, the anchor's seat. The worked structure on seed terms reads the first investor's terms binding the last, and the exclusion set is the mechanism.

The election mechanics

A holder elects the benefit of another's term by notice to the manager within a period after the schedule discloses it, and the election takes effect from a date the constitution sets, usually the election's or the original grant's. The manager then has, for that term, a class of electing holders, and the administrator runs it. Elections of economic terms are the reason the constitution forbids economic letters: a manager that granted one holder a lower charge and receives elections from nine has given the register a lower charge by a letter it meant for one, and the economics of the fund have moved by a page the manager signed at a close.

Where it surfaces

At the administrator's first distribution calculation, when a letter's preference has no class to run on.

At the most-favoured-nation elections, when a concession meant for one reaches nine.

At the regulator's review, when the letters are read against the constitution's classes and the memorandum's disclosure.

At the capital-call lender's grading, when excuse rights without a lender's clause leave holders outside the base.

At the continuation, when a holder's preference on the transfer price is found by the cash holders' counsel.

At the successor fund, when the predecessor's letters are the first thing the register asks for.

The cost of getting it wrong

An economic letter costs, at the elections, the concession multiplied by the register; at the administrator, a waterfall the constitution does not describe; at the review, a finding on equal treatment and conflicts; and at the continuation, a dispute. A class costs an amendment, the existing holders' consent and a disclosure, which is the price of doing in the constitution what the letter tried to do outside it. The schedule costs a page kept current, and the rule to the placement team costs a paragraph.

The concession schedule

A schedule, maintained by the manager and disclosed to each holder at admission and on request, listing every side-letter term granted, the holder, the date, whether it is inside or outside the most-favoured-nation reach and why, and the holders entitled to elect it. The schedule is what lets a later holder see the fund's real economics before it subscribes, and what lets the manager see what the next concession will cost across the whole register before it is granted. A fund without a schedule has letters nobody can total, and a register without a schedule has elections it cannot make.

The centres' rules

Both centres' funds rules require the memorandum to disclose the material terms on which units are offered and require holders of the same class to be treated equally in the respects the rules name; a letter that grants an economic preference to one holder in a class is read by the regulator as a departure from equal treatment unless the constitution created the class and the memorandum disclosed it. The conduct rulebooks' conflicts duty reaches a manager that favours one holder over another for reasons of the manager's own, such as a larger commitment or an anchor's goodwill, without disclosure. The regulators' reviews ask for the side letters and the schedule, and read them against the constitution's classes.

What the constitution should say

It names what a side letter may and may not do. It permits letters on reporting, excuse, confidentiality, regulatory confirmations and committee representation. It forbids letters that alter the charge, the share of gain, the hurdle, the waterfall's ranking, the priority on a distribution in kind or the co-investment economics, and requires any such alteration to be done by creating a class in the constitution, which every holder can read and the affected classes have approved. It requires every letter to be disclosed, in full or in summary, to every holder on request, so that the most-favoured-nation clause can be operated by a holder who knows what to elect. And it gives the committee the right to see the schedule.

The administrator's position

The administrator runs the waterfall on the constitution's classes, and a letter that changes one holder's economics is a letter the administrator cannot run without a class to run it on. A manager that asks the administrator to apply a letter's preference to one holder's distribution is asking it to compute a class the constitution does not contain, and an administrator that does so has computed a distribution the other holders can dispute. The administration agreement says that the administrator applies the constitution's classes and the schedule's letters within the constitution's permission, and nothing else.

The lender's clause

A capital-call lender reads every side letter for anything that qualifies the holder's obligation to fund a lender's call, and requires a lender's clause in each preserving the obligation. An excuse right, a limit after a date, a most-favoured-nation election that may import another holder's qualification: each is a term the lender counts against the borrowing base unless the clause preserves the call. The letters are drafted with the lender's clause from the first, because a letter without it is a holder outside the base.

The continuation and the letters

At a continuation the old fund's letters are read for rights the transaction triggers: a holder's right to be offered any sale of the portfolio, a holder's consent right over a related-party transaction, a holder's preferred position on the proceeds. A letter that gives one holder a preference on the transfer price is a class the continuation's cash holders did not see, and the continuation's process discloses every letter before the vote. The lead investor's own letter in the new vehicle is the same question again: a lead with a preference the rolling holders do not receive has a class the rolling holders did not subscribe beside.

By letter · by kind	Example	Changes what the holder receives	Permitted by letter	Inside the most-favoured-nation reach
Reporting	Quarterly reports in the holder's format	No	Yes	Usually
Excuse	Declining investments the holder's law forbids	No, if excuse is a reallocation	Yes	Tied to the holder's position; usually excluded
Regulatory confirmation	The manager confirms it will not do a stated thing	No	Yes	Usually
Committee seat	A representative on the committee	No	Yes, where the constitution permits	Tied to commitment size; often excluded
Reduced charge or higher share	A lower charge on the holder's units	Yes	No; a class	Inside, unless tied to size
Priority in the waterfall or on a distribution	Paid first	Yes	No; a class	Inside
Co-investment economics	Co-investment without the manager's share	Yes	No; a class or a policy	Inside, unless tied to size

A timeline, as a type

Month one: the constitution names what letters may and may not do; the placement team receives the rule in writing. Month two: the first investor's negotiation; the most-favoured-nation clause's exclusions drafted with the whole raise in view: size classes, regulatory excuses, the anchor's seat, the manager's affiliates. Month three: the first letter, on reporting and excuse as a reallocation, with a lender's clause; the schedule opened. Month four: a holder asks for a lower charge; the manager offers a size class, created by amendment with the existing holders' consent and disclosed. Month six: final close; every holder received the schedule at admission. Year two: a holder elects another's reporting term under the clause; the manager runs it. Year six: the continuation's process discloses every letter; none is economic; the cash holders' counsel finds nothing to dispute. Year seven: the successor's register asks for the predecessor's letters and receives a schedule of reporting, excuse and confirmations.

The structure paper's page

The structure paper's side-letter page carries: the constitution's rule on what letters may and may not do; the most-favoured-nation clause's reach and exclusions, with the reason for each exclusion; the schedule, current; the lender's clause's form; the excuse mechanism as reallocation; the classes created and the amendment procedure used; and the disclosure made to each holder at admission. The page is the regulator's equal-treatment reading done in advance and the successor's register's first question answered.

The onshore registers and letters

Gulf institutions ask for letters as any institution does, and their requests are usually of the first kind: reporting in a form their own governance requires, an excuse right for sectors their own law forbids, a confirmation about the manager's conduct, a committee seat for a large commitment. A sovereign's excuse right tied to its own law is outside the most-favoured-nation reach by the usual exclusion, and a manager that drafts it as a reallocation keeps the lender's base. A Gulf institution that asks for economics is offered a class, as any holder is, and the intermediaries in the Kingdom and Kuwait file the economics as the constitution's classes state them.

The co-investment right by letter

A co-investment right, the holder's right to be offered the excess of an asset alongside the fund, is granted by letter in many funds and is economic in substance: a holder with the right has access to positions without the fund's charge and share, which the other holders lack. The constitution's allocation policy governs co-investment, and a letter that grants a right outside the policy is a class in the policy's terms; the most-favoured-nation clause's treatment of co-investment rights, inside or excluded as tied to size, is read with the policy. A manager that wants to offer co-investment to large holders writes the policy to say so, with the size test, and the letters confirm the policy rather than create the right.

The letter and the landowner's contribution class

On a land platform the landowner's contribution class is a class, created by the constitution, with its own lock-up, distribution position and hurdle base, disclosed to the cash investors, and it is the model for how a holder with a different economic position is accommodated: in the constitution, as a class, with the other holders' knowledge. A landowner accommodated by letter instead, with a preference on its parcel's proceeds nobody else saw, is the class-by-letter problem in its clearest form, and the cash investors' counsel reads it at the first valuation day.

The letter as evidence

Every letter is a document the regulator, the lender, the continuation's adviser and the successor's register will read, and a letter is drafted as the evidence it will be: its purpose stated, its term stated, its relationship to the constitution stated, its lender's clause and its disclosure to the other holders stated. A letter drafted as a favour reads, later, as a favour; one drafted as a documented departure the constitution permits reads as what it is.

The committee's reading of the schedule

The committee sees the schedule under the constitution's provision and reads it for two things: whether any letter is of the second kind, which is a class the committee should have approved as an amendment, and whether the manager has favoured any holder for reasons of its own, which is a conflict the committee's related-party route should have seen. A schedule the committee reviews annually is a schedule whose letters stay within the rule, because a manager that knows the committee will read the next letter drafts it to the rule.

A letter, as a type

A pension institution subscribing a large commitment asks for three things: reporting in its own format, an excuse right for investments in a sector its policy forbids, and a lower charge on its units. The manager grants the first two by letter, with the excuse drafted as a reallocation so that the institution funds the call and is excused from the investment, and with a lender's clause. The third it declines as a letter and offers as a class: a class of units with a lower charge for commitments above a stated size, created by the constitution's amendment with the existing holders' consent, disclosed in the memorandum, with the most-favoured-nation clause excluding it as tied to size. The schedule records the two letters and the class; every later holder sees both; the administrator runs the class; the regulator's review reads a constitution whose classes match its economics.

Four cases, as types

A manager grants an anchor investor a lower charge and a larger share of gain by side letter, on the footing that the anchor's commitment justified it and the letter was confidential. Three holders with most-favoured-nation clauses elect the terms at the first distribution, and the manager's economics on the fund fall by the elections; the holders without the clause learn of the letter from the administrator's calculation and read it as a class they were not told about.

A manager grants a sovereign a preferred position on any distribution in kind by letter. At the term's end the distribution in kind is proposed; the sovereign's preference puts it ahead of the other holders on the one asset; the other holders' counsel reads a class the constitution does not contain and the constitution's amendment procedure was not followed for.

A manager grants excuse rights by letter drafted as exclusions from calls rather than reallocations. The capital-call lender excludes the holders from the base; the facility is a third smaller; the letters had no lender's clause.

A manager's constitution names what letters may and may not do, keeps a schedule every holder sees, drafts every letter with a lender's clause, and creates a class where a holder wants economics. The regulator's review, the lender's diligence and the continuation's process each read a fund whose letters are what the constitution permits.

What each party holds

The manager holds the line between the two kinds, the schedule, and the decision to create a class rather than grant a letter.

Counsel holds the constitution's provision on letters, the most-favoured-nation clause's reach and exclusions, and the class amendment procedure.

The administrator holds the waterfall on the constitution's classes and nothing else.

The lender holds its clause in every letter.

The committee holds the right to see the schedule.

Each holder holds its own letter, the schedule and its election under the clause.

The sequence

1. The constitution names what a side letter may and may not do, and requires economic variations to be classes.
2. The most-favoured-nation clause's reach and exclusions are drafted at the first investor's negotiation with the whole raise in view.
3. The concession schedule is opened at the first letter and disclosed at every admission.
4. Every letter carries a lender's clause and is drafted with excuse as a reallocation.
5. Any economic variation is created as a class by the constitution's procedure and disclosed in the memorandum.
6. The letters and the schedule are read at every continuation and every successor fund.

Questions a manager asks

Can a large commitment be rewarded at all. Yes, by a class for commitments above a size, created in the constitution, disclosed, and excluded from the most-favoured-nation reach as tied to size.

Are confidential letters possible. A letter's contents may be confidential from the public; they are disclosed to the other holders in full or in summary under the constitution, because a letter nobody else can read is a class nobody else subscribed beside.

What if a holder refuses to subscribe without an economic letter. Then it wants a class, and the manager decides whether the class is worth the amendment and the disclosure; a letter is not the answer.

Does a committee seat by letter rank the holder. It changes governance rather than economics; most constitutions permit it and most most-favoured-nation clauses exclude it as tied to size.

What does the regulator read. The letters against the constitution's classes and the memorandum's disclosure, for equal treatment within a class and for conflicts in the manager's favouring of one holder.

What about the lead investor in a continuation. Its terms are a class in the new vehicle or they reach the rolling holders; a lead's letter the rolling holders did not see is the continuation note's commonest failure.

The holder who negotiated the letter wanted a better position, and it will keep a better position only if the position was created in the document everybody signed, because a position created in a document nobody else saw is a position the others may undo when they see it.

Terms used

Side letter: an agreement between the manager and one holder outside the constitution.

Class: a set of units with stated rights created by the constitution and disclosed in the memorandum.

Most-favoured-nation clause: a holder's right to elect the benefit of terms granted to another, within a stated reach.

Reach and exclusions: the terms the clause covers and those it excludes, such as terms tied to size or to a holder's regulatory position.

Concession schedule: the manager's record of every side-letter term, who holds it and who may elect it.

Lender's clause: the side-letter provision preserving the holder's obligation to fund a lender's call.

What to read

The constitution's provisions on side letters, classes and the amendment procedure; the most-favoured-nation clause; the concession schedule; the centres' funds rules on disclosure and equal treatment and the conduct rulebooks' conflicts duty; the facility's requirements on side letters. On this site, the economics and vehicles rooms under Structures and the worked structure on seed terms.