Most-Favored-Nation Effects in Private Equity: Uncertain. This article originally appeared in Law360, New York (March 02, 2015, 2:01 PM ET).

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1 Most-Favored-Nation Effects in Private Equity: Uncertain This article originally appeared in Law360, New York (March 02, 2015, 2:01 PM ET). Side letters in favor of investors in private investment funds have become customary. This article focuses on the operation of a side letter s most-favored-nation provision (MFN) on the substantive provisions of another investor s side letter. It is believed that significant uncertainty pervades that interaction, as a function of differing perspectives on the scope of benefits arising in those substantive provisions. Investment fund ( Fund ) side letters overrule the limited partnership agreement, limited liability company agreement, or similar governing document of the Fund (the Fund Agreement ), a structural feature that is typically embodied very clearly in the Fund Agreement itself. The MFN, however, generally appears in the side letter entered into by the Fund in favor of an investor whose capital participation in the Fund is sufficiently important to enable it to receive beneficial overrides and additions to the Fund Agreement. The basic MFN language appearing in side letters is something like this: The Investor is entitled to the benefit of any provision that appears in a side letter of any other Investor in the Fund. That clause generally precedes a proviso that sets forth important carveouts, including the following: provided that... any benefit so granted to another investor in connection with specific statutory, regulatory, or other legal requirement applicable to such investor but not applicable to the investor signatory hereto shall not be available to the Investor signatory hereto under this MFN. The familiar regulatory imperatives referred to in the proviso, frequently arising in guidelines applicable to investments by governmental pension systems, can result in lengthy side letters for such investors. The operation of MFNs on governmentally mandated side letter provisions is relatively straightforward. If State X requires its governmental retirement systems to require that private investment funds in which such a system invests must agree to use commercially reasonable efforts to find investments in State X, that requirement will (if not addressed in the Fund Agreement) find its way into the side letter between the Fund and a State X municipal employees retirement system that is investing in the Fund. If State Y has the same requirement for its retirement systems, the requirement will be written into the side letter of an investing State Y retirement system. Obviously, under those circumstances neither a State X retirement system investor nor a State Y retirement system investor will need its MFN for that result, because each will have its own side letter clause. Furthermore, it seems quite clear that an investor not subject to such a regulatory requirement will not, through attachment of its MFN to the governmentally mandated provisions

2 in the side letters of the retirement systems, be able to get the Fund s agreement to look for investments in such investor s home state. But the very ease with which determinations about the application of the MFN can be made in the case of such governmentally mandated side letter provisions may well be responsible for dangerous optimism about the functioning of MFNs in other contexts. In the examples that follow, the hypothetical Fund has entered into a side letter with Investor One, an investor that is not subject to the kind of legal influence referred to in the above proviso in the MFN clause. We imagine that the MFNs of the other investors all have the language set forth above, containing no basis for excluding MFN operation on any provision in Investor One s side letter. Therefore, any beneficial provisions that Investor One has exacted from the Fund are fair game for the MFNs of other investors. But what exactly do the other Investors get through their MFNs? Example 1: Forum for Disputes Paragraph 36 of Investor One s side letter has a provision to the effect that all claims against the Investor in connection with the Fund shall be brought in the courts of State N. Both the Fund Agreement and Investor Two s side letter are silent on forum for disputes. Case A. Investor One has its executive offices and conducts most of its business in State N, while Investor Two has its executive offices and conducts most of its business in State M. In the given facts, is Investor Two entitled to have the Fund s agreement that claims against Investor Two be brought in Investor Two s home state, State M? Is Investor Two entitled to have claims against it brought in State N, the result for Investor One under Investor One s paragraph 36? (Do these questions have anything to do with what happens under paragraph 36 if Investor One relocates its offices and business to State Q?) Case B. Paragraph 36 of Investor One s side letter is the same except for the additional requirement that the court in which the claim is brought must be located in Metro City, which is State N s largest city and a major national commercial center. State N courts will accept cases involving out-of-state litigants. Under the changed facts, does Investor Two s MFN entitle Investor Two to have claims against it brought in State N courts located in Metro City? Given the attributes of Metro City as a major commercial center, does Investor One s location continue to have relevance to the inquiry? Would Investor Two be entitled to the Fund s agreement that claims against Investor Two be brought in the courts of State R (whose courts are notoriously protective of investors and also accept out-of-state litigants) venued in State R s equally commercially important Enterprise

3 City? It is difficult to maintain that Investor Two is entitled to nothing under its MFN. The choice of forum in Investor One s side letter clearly is thought by Investor One to be to its benefit. Investor Two justifiably regards itself as entitled to something through its MFN, but what? In Case A, Investor One s paragraph 36 could have (but did not) set forth something to the effect that the forum selection was made in order to have claims heard in the Investor s area of operation. In Case B, the language could have specified (but did not) that the selection was made in order to take advantage of the commercial experience of Metro City tribunals (although it is debatable whether that additional language would support, or undermine, an MFN election by Investor Two to have claims against it brought in Enterprise City rather than Metro City). Example 2: Additional Information Paragraph 16 of Investor One s side letter requires that the Fund shall furnish to the undersigned Investor, within 45 days after the end of each calendar quarter, in addition to any information required to be furnished under the Fund Agreement, a report of the Fund s Adjusted Net Asset Value as defined in and calculated in accordance with the methodology set forth in the attached Schedule A to this Letter. In this example, we imagine that the MFN application requires written election. For convenience, certain language in the MFN election notices of other investors has been italicized below. Investor Three elects application of its MFN as follows: In Paragraph 16 of Investor One s side letter the Fund agrees to furnish to Investor One additional financial information in the nature of a specified calculation relating to the value of the Fund s assets. Pursuant to the MFN in our side letter, we elect also to be furnished with such information, at the same times set forth in Paragraph 16 of Investor One s side letter. Investor Four elects application of its MFN as follows: In Paragraph 16 of Investor One s side letter the Fund agrees to furnish to Investor One additional financial information relating to the Fund. Pursuant to the MFN in our side letter, we elect also to be furnished with additional financial information relating to the Fund. Such additional financial information shall consist of a report to be furnished, within 60 days after the end of each calendar quarter, of the 'Applicable Net Incremental Performance' of the Fund as defined in and calculated in accordance with the methodology set forth in the attached Annex A to this notice. Investor Five elects application of its MFN as follows: In Paragraph 16 of Investor One s side letter the Fund agrees to furnish to Investor One additional information relating to the Fund. Pursuant to the MFN in our side letter, we elect also to be furnished with additional information relating to the Fund. Such additional information shall consist of a report to be furnished, within

4 30 days after the end of each calendar quarter, of the Fund s charitable and social policy activities conducted in the preceding quarter. Of the three investors, Investor Five sets forth the broadest view of the benefit conferred under Investor One s Paragraph 16, i.e., that it is the right to additional information relating to the Fund. Under Investor Five s construction, that additional information need not necessarily relate to asset valuation or any other financial information. Investor Five sees the benefit as information, per se. It is important to note that in example 2, the different perceptions arise notwithstanding that Investor One s Paragraph 16 is very specific in delineating what Investor One is to receive. That seeming disconnect illustrates a central point. Precisely because of its long perspective, Investor Five s epistemological viewpoint effectively dismisses the specificity as a short-sighted understanding of Paragraph 16. In the matter of what is perceived, the viewer s perspective is always as important as the object of scrutiny. Further examples easily can be constructed to illustrate these issues, but answering the questions raised must fall to careful drafting of the side letter clauses (including the MFN itself) to focus the scope in a manner that reveals the intent. By Thomas Volet, Moses & Singer LLP Thomas Volet has been a partner with Moses & Singer since 1983 and has been involved in the representation of financial institutions since the early 1980s. He is currently co-chair of the firm's banking and finance practice. The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

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