Most favored nation (MFN)

Most favored nation clauses protect investors from getting worse deals than other investors in the same fund. These clauses appear in side letters Side letter Side letters are separate agreements between a hedge fund and a specific investor that modify or supplement the standard fund terms, typically granting special rights or preferences to large or strategic investors. , which are separate agreements that modify the main fund contract for specific investors.

Fund managers negotiate these provisions more frequently now. Recent studies show that MFN provisions appear in about 41% of side letters as of 2024. This represents a major increase from previous years. The growth reflects how investors have become more sophisticated and want fair treatment compared to other fund participants.

Fund sponsors encounter two main types of MFN structures when setting up these protections.

The first type gives investors access to any side letter benefits that current or future investors negotiate. This approach applies regardless of how much money each investor contributes to the fund.

The second type, called "schoolyard MFNs," works differently. These provisions only protect investors from getting worse terms than investors who contribute the same amount or less money. This creates different tiers based on investment size. Larger investors may receive better terms than smaller ones under this approach.

Fund managers need to carefully decide which investors and situations should be excluded from MFN coverage. Industry practice typically exempts certain affiliated parties from these protections.

Standard exclusions include general partner employees, their family members, and related charitable organizations. Fund managers also commonly exclude strategic investors who provide value beyond money. Examples include investors who provide seed capital or bring industry expertise to the fund.

Additionally, terms that address specific legal, regulatory, or tax requirements usually fall outside MFN scope. These accommodations serve narrow compliance purposes rather than giving general preferential treatment to certain investors.

The regulatory landscape changed in 2024 when the Fifth Circuit Court of AppealsFederal appellate court that reviews decisions from district courts in Texas, Louisiana, and Mississippi. struck down the SEC's Private Fund Adviser RulesSEC regulations that would have imposed additional disclosure and operational requirements on private fund advisers before being overturned by the Fifth Circuit Court of Appeals.. Regulatory oversight of side letter practices now relies on traditional fiduciary dutyLegal obligation to act in the best interests of another party, requiring utmost good faith and loyalty. principles and anti-fraud provisionsRegulatory requirements that prohibit deceptive or misleading practices in financial communications and transactions..

Recent enforcement actions show that the SEC continues to focus on preferential treatment that may harm non-redeeming investors. The agency particularly scrutinizes enhanced liquidity rightsContractual provisions that specify when and under what conditions investors can withdraw their capital from an investment fund, including redemption frequency, notice periods, and any applicable restrictions or gates. that could trigger increased redemption activity. When some investors redeem their shares more easily, it can reduce fund liquidity for remaining participants.

Fund managers have fiduciary duties to treat all investors fairly. Regulators examine whether certain arrangements create conflicts of interest or unfairly advantage some investors over others.

Managing MFN provisions effectively requires fund managers to make several operational decisions that significantly impact how the fund operates.

Sponsors must determine whether MFN coverage includes all negotiated provisions or only covers core elements like fees and liquidity terms. Investment aggregationThe methodology for combining or counting multiple investment commitments from affiliated entities or related parties to determine applicable terms, thresholds, and investor classification for regulatory and contractual purposes. rules need careful definition. This becomes particularly important when dealing with affiliated investor commitments and capital referred by gatekeepers.

The measurement method for schoolyard provisions also matters. Fund managers must decide whether to base calculations on initial commitments or current net asset values. This choice affects ongoing MFN calculations throughout the fund's life.

Most importantly, sponsors must establish whether investors can selectively choose beneficial terms while avoiding the associated obligations and restrictions that typically come with those terms.

Current regulatory expectations emphasize comprehensive disclosure about fund sponsors' authority to grant preferential terms through side letters. Fund managers must establish clear documentation showing their operating agreements Operating agreement An operating agreement is the primary governing document for a hedge fund structured as a limited liability company (LLC). It establishes how the company will be owned, managed, and operated, including rules for capital contributions and profit distributions. provide the necessary authority to execute side letters.

Recent enforcement patterns show that inadequate disclosure of preferential arrangements can lead to serious consequences. Investors may file lawsuits alleging fraud and breach of fiduciary duty when they discover undisclosed preferential terms given to other investors.

Fund managers should clearly explain in their fund documents how side letters work and what authority they have to negotiate different terms with different investors.

The operational complexity of managing MFN provisions has driven significant changes in how the industry handles these arrangements. Many fund managers now use pre-configured side letter templates and digital MFN election systems. These tools help manage the administrative burden more effectively.

This standardization trend accelerated in 2024-2025. Technology platforms now facilitate streamlined MFN processes that reduce processing time from weeks to hours while maintaining compliance oversight.

The industry has matured in handling these increasingly common provisions. Modern approaches help balance meaningful investor protections with operational efficiency. Fund managers can now provide fair treatment to investors without creating overwhelming administrative burdens.