Side letters and MFN management: the conflicts and disclosure the FCA reads as fairness
SYSC 10; the AIFMD fair-treatment-of-investors obligation and the related investor-disclosure requirements (onshored in the FCA's FUND sourcebook); the FCA's fair-treatment principles; ILPA's side-letter and most-favoured-nation guidance; and the now-vacated SEC preferential treatment rule.
Most of what a side letter contains is commercially significant and harms no one outside the deal. A fee discount comes out of the manager’s pocket. A bespoke reporting format is an administrative courtesy. Two terms are the exception, and they need active management. When one investor has negotiated shorter redemption notice or an exemption from a gate, and the market turns, that investor gets out first, at a NAV struck before the book has repriced the trouble, and the cost of funding the exit falls to the investors who stayed. That is preferential liquidity. Preferential transparency does similar harm through better information. The FCA has no rule headed “side letters”. It reads the book through the conflicts regime and the fair-treatment obligations that run through the fund rules, and those two terms are where a well-run firm has to concentrate.
Take the conflict-light terms first, since they’re the bulk of any book. A fee discount costs the manager, not the other investors. A key-person clause protects the investor who holds it without touching the fund. These need disclosing and running through an MFN process, but on their own they disadvantage no one. The fairness question turns on the other two.
Preferential liquidity is the ability to leave on better terms than the rest of the fund: shorter redemption notice, exemption from a gate or lock-up, more frequent dealing. The term is inert in calm markets and advantageous in stress. When stress hits and everyone wants out, the investor with the better terms redeems first, at a NAV struck before the portfolio has fully repriced the difficulty; meeting that redemption means selling the most liquid assets first, and the investors left behind are then holding a more concentrated, less liquid, lower-quality residual. In stress, the investors who stayed bear the cost — a first-mover advantage.
Preferential transparency is the ability to see what others can’t: portfolio- or position-level information, or reporting on a faster cadence. Often it’s benign, and the investor simply manages its own risk better. The fair-treatment concern is the favoured investor who redeems on better information ahead of investors still reading last quarter’s summary, stacking the information advantage on top of the liquidity advantage to exit cleanly while the rest are still deciding. It’s the quieter of the two conflicts, and the one more often missed.
Both are the terms the SEC’s preferential treatment rule singled out, and both are the terms most likely to fail a fair-treatment test, because one investor’s use of them harms the others directly.
There is no single FCA rule headed “side letters”, which is why firms underrate the regulatory weight here. The obligation is assembled from three sources, and together they’re demanding.
Start with the conflicts regime. Under SYSC 10, a conflict exists wherever the firm has an incentive to favour the interest of one client, or group of clients, over another. A side letter granting preferential terms is the textbook case. The firm has to identify the conflict, manage it, and, where management isn’t enough, disclose it, and it has to be able to show it did all three rather than point to a conflicts policy that mentions side letters in the abstract.
Second is the fair-treatment obligation in the fund rules. A manager inside the AIFMD framework must treat the fund’s investors fairly, and the standard attached to preferential treatment is specific: any preferential treatment given to one or more investors must not result in an overall material disadvantage to other investors. That’s the test to apply to every preferential liquidity and transparency term before granting it. The fair-treatment test bars terms that materially disadvantage the rest of the fund, regardless of the investor’s size.
Third is disclosure. For a UK fund the Handbook rule is FUND 3.2.2R, which carries the AIFMD Article 23 investor-information requirements. Among the matters that must be disclosed before investment are the manager’s fair-treatment arrangements and any preferential treatment of an investor: how fair treatment is ensured and, where an investor obtains preferential treatment, a description of that treatment, the type of investors who get it, and their legal or economic links to the fund. This sits in the pre-investment disclosure rule, made before investment and updated for material changes. The effect is that the existence and categories of preferential treatment have to be visible to the investors who don’t receive it.
Over all of this sit the conduct principles, and one distinction is worth getting right. Principle 8, the duty to manage conflicts of interest fairly, is the principle that governs side-letter and MFN conflicts. For retail business, Principle 12, the Consumer Duty, has displaced the older treating-customers-fairly Principles 6 and 7 under PRIN 2A.1.3, so a retail-facing fund should run its fairness argument through the Consumer Duty rather than Principle 6.
The most explicit version of this standard came, briefly, from the SEC. In 2023 the SEC adopted a preferential treatment rule that would have barred a private fund adviser from granting preferential redemption rights, or preferential portfolio-holdings and exposure information, where the adviser reasonably expected the term to have a material negative effect on other investors, subject to limited exceptions; it would also have required advisers to disclose all preferential terms. The rule named the same two terms, liquidity and transparency, as the high-risk preferences, and built its prohibition on the material-disadvantage test the AIFMD framework already contained.
In June 2024 the US Court of Appeals for the Fifth Circuit vacated the SEC’s private fund adviser rules in their entirety. The SEC rule was vacated, but the standard it expressed still applies through the FCA’s framework. ILPA’s guidance already pushes funds toward MFN processes and disclosure of preferential terms, and a UK fund’s own fair-treatment obligation already prohibits preferential treatment that materially disadvantages other investors. Most UK hedge funds have US investors. For those firms, the conduct the SEC rule would have required (no materially harmful preferential liquidity or transparency, and full disclosure of preferential terms) is the conduct to adopt regardless, because the FCA’s fairness framework points to the same place.
A fund can grant side letters, including to its most important investors, and stay on the right side of the fairness test, as long as it runs the book as a controlled system rather than a run of one-off negotiations. Seven things hold it together.
A complete register. One list of every side letter and every term inside it, kept current as letters are signed, not assembled the week a due-diligence request arrives. A fund that can’t produce a definitive who-has-what on demand can’t manage the conflicts the book creates, because it doesn’t fully know what they are.
Terms sorted by conflict risk. Each term classified by the conflict it creates, with preferential liquidity and transparency flagged high-risk and the benign terms recorded but handled proportionately. That’s what lets a firm put its fairness analysis where it counts.
A material-disadvantage assessment for the high-risk terms. Before granting any preferential liquidity or transparency term, the firm assesses and records whether it would materially disadvantage the other investors. If it would, the firm doesn’t grant it, or extends it to all, because the fair-treatment standard doesn’t allow a preferential term that materially harms the rest of the fund. Made and written down at the point of granting, this assessment is the main piece of evidence the framework produces.
A working MFN process. Where investors at or above a commitment threshold hold most-favoured-nation rights, the firm must run the election: circulate the relevant other side-letter terms, give investors the chance to elect equivalent treatment, and record who was offered what and who elected. An MFN clause granted but never run is a breach. A tiered MFN, where larger investors see more, has to be applied as written.
Disclosure of preferential treatment. The firm discloses to all investors how it ensures fair treatment and the existence and categories of preferential treatment granted, in line with the fund-rules obligation. This doesn’t mean publishing every investor’s bespoke deal. It means an ordinary investor knows that preferential liquidity or transparency terms exist and broadly what kind of investor holds them. Because the obligation is satisfied at the level of categories and investor types rather than named counterparties and exact terms, a fund can say that certain large or early investors hold preferential liquidity or transparency rights without breaching anyone’s confidentiality. A demand to keep preferential terms secret is a red flag against the fairness test.
Honouring and reconciliation. Terms most often fail at the operating stage: granted but never applied. A term has to be honoured in practice — the favoured investor’s shorter notice period applied by the administrator, the enhanced reporting delivered on the agreed cadence, the fee discount charged. The register has to be reconciled against what the fund and its administrator actually do.
Governance. The board or the relevant committee should see the side-letter book, the high-risk terms, the material-disadvantage assessments and the MFN process, as part of the firm’s conflicts oversight.
- High risk, needing a material-disadvantage assessment before granting: preferential liquidity (shorter notice, gate or lock-up exemptions, more frequent dealing) and preferential transparency (portfolio- or position-level information, or more frequent reporting). One investor’s use of these can harm the rest of the fund, so they’re the terms to assess, limit and disclose most carefully.
- Medium risk, needing disclosure and MFN but rarely materially disadvantageous: most-favoured-nation rights themselves, capacity and co-investment rights, and key-person provisions.
- Lower risk, needing recording and MFN treatment but little fairness analysis: fee discounts borne by the manager, bespoke reporting formats, and administrative accommodations.
A book run this way differs from a weaker one in a few concrete places. The register is live and kept as letters are signed rather than filed away with the legal documents. Each high-risk term carries a material-disadvantage assessment recorded at granting, not a conflicts policy that notes side letters exist. The MFN election is run and tracked rather than sitting unused in the letters, and the administrator operates each term against the register instead of the terms living only in the contracts.
This insight is provided for general informational purposes only and doesn’t constitute legal, investment, or regulatory advice.