Most Favoured Nation (MFN) Clause

Large investors negotiate. A pension fund writing a big cheque may ask for a lower management fee or a seat in investment committee meetings, recorded in an investor side letter. Having won those terms, it wants to be sure a later investor does not quietly get better ones.

That is the Most Favoured Nation (MFN) clause. The workbook describes it as a protection right that protects an investor from the risk of any other investor being placed in a better position than them.

The clause creates a tension. The investment manager owes a fiduciary duty to all investors, so it cannot simply hand one investor better economics at others' expense. The workbook's resolution: to avoid breaching that duty, most investment managers create a separate class of units with differential rights, issued to the large investors.

Where MFN terms live

Limits on differential rights (5.16.1). Investors in a scheme have rights pro-rata to their commitments in each investment and in distributions. Differential rights to select investors are allowed only if they:

• do not make any investor accrue a liability to other investors;
• do not give non-monetary control of decisions to an investor, unless it is on the Investment Committee;
• do not alter the existing rights of other investors; and
• are transparently disclosed in the PPM, with eligibility criteria and how to opt in, following SFA implementation standards.

Tax angle (9.1). The high tax rates on a Category III AIF's income are indirectly borne by all unit holders, unless some investors get preferential tax treatment on account of MFN clauses in their side letters.

Losses. Whatever an MFN clause secures, one large investor cannot be given priority over others when losses are distributed.

Illustrative figures. Mahanadi Employees' Pension Trust commits Rs 50 crore to a Category III AIF. Its side letter gives it a 1.50% management fee (headline rate 2.00%) and an MFN clause.

Nine months later Kosi Insurance commits Rs 60 crore and negotiates 1.25%.

What the MFN clause triggers. Mahanadi must not be in a worse position than Kosi on comparable terms, so it becomes entitled to 1.25% too. On Rs 50 crore of assets attributable to Mahanadi:

Fee at 1.50% = Rs 75,00,000 a year
Fee at 1.25% = Rs 62,50,000 a year
Saving       = Rs 12,50,000 a year (before GST at 18%)
With GST     = Rs 12,50,000 × 1.18 = Rs 14,75,000

How the manager delivers it. Rather than changing fees for the whole fund, it issues Mahanadi and Kosi units of a separate class carrying the 1.25% fee, disclosed in the PPM with its eligibility criteria. Other investors' rights are untouched, no one takes on a liability to anyone else, and the manager stays within its fiduciary duty.

What MFN cannot do. If the fund later distributes losses, Mahanadi cannot be shielded ahead of the smaller investors.

Chapter 4 (Category III AIF: Fund Structures and Service Providers) defines the MFN clause under investor side letters in onshore documentation and ties it to separate classes of units. Chapter 9 (Taxation) notes MFN clauses as the exception to all unit holders indirectly bearing the fund's tax, and Chapter 10 (Good Practices) lists MFN clauses among key terms in a pitch book. Chapter 5's pro-rata and differential-rights rules set the boundaries.

• MFN protects against another investor being placed in a better position — it does not itself grant a specific fee or return.
• It lives in the investor side letter, not the contribution agreement's standard terms.
• The manager's fiduciary duty is to all investors, which is why differential rights go through a separate class of units.
• Differential rights must be disclosed in the PPM and cannot alter other investors' existing rights or give control outside the Investment Committee.
• No priority in loss distribution for any large investor.