Happy Friday, Funds Family!

Today is the day you’ve been waiting for…negotiation tactics.

🤝 Choosing a Negotiation Strategy

After the general partner (GP) finishes the first draft of the fund documents, the GP sends the documents to potential investors (LPs).

At this point, the LPs have three options:

1. Invest ✅ 

2. Don’t invest 🛑 

3. Indicate interest, but negotiate for better terms 🧐 

If LPs choose Door #3, the GP has three options:

1. Decline the attempt to negotiate (“Take it or leave it!”)

2. Change the terms of the fund documents

3. Enter into a “side letter” with one or more LPs

📄 Changing the terms of the fund documents

The simplest way to negotiate is to revise the fund documents.

For example, let’s say the fund has a management fee of 2% but an LP wants a management fee of 1.5%.

The GP could revise the fund documents: 2% ➡️ 1.5%. Easy!

In this case, the new 1.5% management fee would apply to all LPs in the fund. It’s a major change to the GP’s fee income.

✉️ Side letters

Changing the fund documents as described above is like using a flamethrower to kill a housefly. 🧑‍🚒 It’s not targeted and can result in collateral damage.

If you have one LP who wants a fee reduction from 2% to 1.5%, why not give just that single LP a fee reduction?

You can!

A side letter is a bilateral contract between the fund/GP and a single LP, where the LP gets special rights not granted to the other LPs. ✨ 

Common side letter provisions include:

• Fee reductions

• Carried interest reductions

• Right for the LP to transfer its fund interest to an affiliate

• Special information rights

• Rights to invest in future funds

• Special tax/regulatory provisions

• Right to be excluded from certain types of investments

We’ll do a deep-dive 🏊‍♂️ into side letters next week.

⚠️ Most-Favored Nations (MFN) provisions

One side letter provision to look out for is a most-favored nations (MFN) right. This is a huge one!

If an LP has an MFN, it has the right to peek 🔎 at all the other LPs’ side letters and take provisions for its own side letter.

So, if another LP has a carried interest reduction from 20% to 15%, the LP with an MFN can swipe that carry reduction for itself! 🦹 

In practice, MFNs are often subject to restrictions, such as the following:

• Investment size. The MFN does not entitle the LP to look at side letters with LPs investing more than the LP with the MFN.

• Affiliated LPs. The MFN does not entitle the LP to look at side letters with LPs affiliated with the GP entity (such as the fund principals).

• Specific carveouts. Many MFN provisions carve out specific rights, which are not subject to MFNs. Examples include special regulatory/tax provisions or the right to be on the LP advisory committee. This list of carveouts is often negotiated.

💡 Tips for MFNs:

• LPs: If you are a large investor, consider asking for an MFN.

• GPs: Be careful when offering side letter terms. If a later investor gets an MFN, they may be able to take special provisions you granted to earlier LPs. Avoid offering MFNs, especially more than one MFN per fund or syndication.

👨‍👩‍👧‍👦 Classes of Limited Partners

In some cases, GPs might divide LPs into classes based on the LP’s check size.

For example:

• Class A: LPs who invest at least $1 million

• Class B: LPs who invest less than $1 million

Class A investors might have lower management fee percentages, lower carried interest, higher preferred returns, or special information rights. 🔬 You can get creative!

This is a great way to incentivize LPs to invest more money. 💸 

✍️ Negotiating specific fund terms

Let’s investigate negotiation tips for LPs and GPs for six real-life fund deal terms. 👀 

We’ll refer to concepts discussed in last week’s article on 20 key terms in investment funds and syndications. If you’re unfamiliar with a term - go check out that post.

Let’s do it. 👍️ 

1️⃣ Carried interest and management fees

GPs

• Create classes of LPs and give lower carry splits, lower management fees, and higher preferred returns to LPs who invest more money

• Avoid management fee offsets (things that reduce the management fee)

• Avoid giving LPs slices of carried interest

• Include a GP catchup in your distribution waterfall

LPs

• Ask for lower carry splits, lower management fees, or higher preferred returns via side letters

• Ask for the management fee to go to zero once the GP starts extending the term of the fund

• Negotiate management fee offsets for excess organizational expenses, placement fees, and transaction fees

• If you’re a reallllllly big LP (an anchor), ask for a piece of the carried interest

2️⃣ Subsequent closings

GPs

• Offer management fee discounts to LPs who invest at the initial closing date

• Offer other terms only available to investors who join early

LPs

• Ask for the GP to waive the “catchup” interest payment if you come in after the initial closing date (I don’t love this, but some funds will do it for big investors)

3️⃣ Fund Expenses

GPs

• Have a broad but reasonable list of “fund expenses” payable by the fund

• (You’ll want to keep costs down regardless, as the more you spend, the longer it will take to return capital and earn carried interest)

LPs

• Negotiate the removal of any fund expenses that you think should be payable by the GP (examples: GP salaries, office rent, and equipment)

• Include a cap on organizational expenses

4️⃣ GP Removal

GPs

• Include only “for cause” removal or decline to include a GP removal provision altogether

• Require a high percentage of LPs to vote for removal (i.e., 80%) 🖐️ 

• Include a narrow definition of “cause” (perhaps only fraud or willful misconduct)

• For removal “for any reason,” include a grace period (i.e., you can’t be removed in the first two years) 🕜️ 

LPs

• Include “for cause” and “for any reason” removal

• Require a low percentage of LPs to vote for removal (i.e., a majority)

• Include a broad definition of “cause” (fraud, willful misconduct, violation of law, gross negligence, reckless conduct, etc.)

5️⃣ Co-Investments

GPs

• Permit the GP to allocate co-investments in its discretion

• Permit the GP to charge whatever fees/carry it wants at the co-investment level

LPs

• Include pro-rata rights permitting LPs to invest in co-investments (in the same proportion as their ownership in the main fund/syndication)

• Negotiate reduced fees/carry for any co-investments

6️⃣ Clawback

GPs

• Remove clawback if it would be appropriate to do so (unusual for closed-end multi-asset funds)

• Decline to have the fund principals (the humans running the fund) personally guarantee the clawback

• Decline any of the other points mentioned for LPs below 🛑 

LPs

• Insist on including a clawback 🦀 

• Require the fund principals to personally guarantee the clawback

• Test the clawback multiple times throughout the fund’s life

• Require some of the carried interest to be kept in escrow at the fund level before distributing it to the GP 💸 

Thanks for reading, everyone.

Have a great weekend! 🙌 

⚠️ Note: This newsletter is for informational purposes only and nothing should be considered legal advice. For that, hire a lawyer! I am a lawyer, but not your lawyer (unless I actually am your lawyer because you’ve signed an engagement letter and we’re working together). This newsletter may be considered attorney advertising.