Most Favored Nation Clauses in PE Funds: Protecting LP Rights Through MFN Provisions

The 2025-2026 fundraising cycle is forcing a structural recalibration of limited partner (LP) rights in private equity, with Most Favored Nation (MFN) clauses emerging as the primary battleground. According to Preqin’s Q1 2025 Fund Terms Report, 68% of closed-end PE funds raised in 2024 included an MFN provision, up from 52% in 2020 and 41% in 2018. This acceleration is not a function of market sentiment but of structural necessity: dry powder held by Asia-focused funds reached USD 678 billion as of 31 December 2024 (AVCJ, January 2025), while the number of institutional investors committing to first-time fund managers in Hong Kong and Singapore fell 14% year-on-year. LPs are demanding contractual mechanisms that preserve economic parity across vintages, and fund sponsors—particularly those targeting Hong Kong-domiciled vehicles under the HKMA’s revised 2024 External Manager Guidelines—must now treat MFN clauses as a standard fixture of limited partnership agreements (LPAs), not a negotiable concession.

The Structural Anatomy of MFN Clauses in Hong Kong-Domiciled PE Funds

An MFN clause in a PE fund LPA grants an existing LP the right to electively adopt any more favorable economic or governance terms that the general partner (GP) subsequently offers to a later-vintage investor. The mechanism is distinct from a side letter: an MFN is a fund-level provision, while a side letter is bilateral between the GP and a specific LP. In Hong Kong, where the Limited Partnership Fund Ordinance (Cap. 637, LFO) governs the legal framework for private funds, MFN clauses operate within the contractual architecture of the LPA rather than through statutory default rules. Section 14 of the LFO explicitly preserves freedom of contract for partnership agreements, meaning MFN provisions are enforceable as written, provided they do not contravene the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615).

Scope of Coverage: Economic vs. Governance Provisions

The most critical distinction in MFN drafting is between economic MFNs and governance MFNs. An economic MFN covers fee structures—management fees, carried interest percentages, hurdle rates, and preferential return waterfalls. A governance MFN covers board observer rights, key person clauses, removal rights, and information rights. Data from the 2024 Hong Kong Venture Capital and Private Equity Association (HKVCA) Fund Terms Survey indicates that 74% of MFN clauses in Hong Kong-incorporated funds cover both categories, but the trigger mechanisms differ materially. Economic MFNs typically operate on a “most favorable” basis, meaning the LP can elect any single term from a later investor’s package. Governance MFNs frequently operate on a “basket” basis, requiring the LP to adopt the entirety of the later investor’s governance package rather than cherry-picking individual provisions.

The Compliance Trigger: When Does an MFN Activate?

An MFN clause must specify the trigger event. The standard approach in Hong Kong fund documentation is a “subsequent closing” trigger: the MFN activates when the GP holds a subsequent close of the fund at a net asset value (NAV) that includes capital contributions from new investors. However, an emerging practice in 2025 is the “material amendment” trigger, where the MFN activates if the GP amends the LPA to grant any existing LP—not just a new investor—a more favorable term. This second trigger is more common in funds with a single institutional anchor LP, where the GP may grant the anchor a side letter and then face MFN claims from other LPs. The SFC’s 2023 Code of Conduct for Fund Managers (Chapter 5, Paragraph 5.4) requires that any differential treatment of LPs be disclosed in the fund’s offering memorandum, and MFN clauses that are not triggered by side letters may still create disclosure obligations if the GP knows of the differential treatment.

Negotiating MFN Clauses: The GP-LP Tension Points

The negotiation of MFN provisions is where the economic interests of GPs and LPs diverge most sharply. For GPs, the risk is that an MFN clause creates a “race to the bottom” on fees: a single concession to one LP cascades across the entire LP base, eroding the GP’s fee income. For LPs, the risk is that an MFN is drafted so narrowly that it captures only trivial terms while the GP structures material concessions as bespoke side letters that fall outside the MFN’s scope. The 2024 HKVCA survey found that 31% of fund managers reported at least one MFN-related dispute in the previous 12 months, with the majority turning on the definition of “more favorable term.”

The Side Letter Carve-Out: A Structural Tension

The most contested issue in MFN drafting is whether side letters granted to individual LPs are subject to the MFN. The standard GP position is that side letters are bilateral agreements and fall outside the MFN’s scope, on the basis that the MFN applies only to terms in the LPA itself. The standard LP position—increasingly codified in institutional investor guidelines from the Hong Kong Monetary Authority (HKMA) and the Mandatory Provident Fund Schemes Authority (MPFA)—is that any term offered to any LP, whether in the LPA or a side letter, should be subject to the MFN. The HKMA’s 2024 Circular on External Manager Governance (HKMA Circular B10/1C, 15 March 2024) explicitly states that “fund managers engaging with HKMA as a limited partner should ensure that any side letter terms offered to other investors are made available to the HKMA on an MFN basis, unless a specific exemption is justified in writing.” This regulatory position has effectively become the market standard for Hong Kong-domiciled funds seeking institutional capital.

The Time Horizon Problem: Vintage-Based MFN Structuring

A structural challenge unique to closed-end funds is the vintage-based nature of MFN clauses. If a fund holds multiple closes over 12-18 months, the economic terms offered to later closings may be more favorable if market conditions deteriorate. An MFN clause that applies to all subsequent closes can lock the GP into a downward fee trajectory. The solution increasingly adopted in Hong Kong fund documents is the “vintage MFN” structure: the MFN applies only to closings that occur within the same calendar year or within a specified time period (typically 12 months from the initial close). After that period, the MFN resets. This structure is supported by Section 18(3) of the LFO, which permits the LPA to specify the duration of any LP right. Data from law firm Debevoise & Plimpton’s 2025 Fund Formation Survey shows that 62% of Asia-focused funds now use a vintage MFN structure, up from 43% in 2022.

Enforcement Mechanisms and Dispute Resolution Under Hong Kong Law

An MFN clause is only as effective as its enforcement mechanism. In Hong Kong, where the LFO does not provide a statutory remedy for MFN breaches, enforcement depends entirely on the contractual language and the dispute resolution framework in the LPA. The standard enforcement mechanism is the “opt-in” right: upon receiving notice of a subsequent close with more favorable terms, the existing LP has a specified period—typically 30 to 60 days—to elect in writing to adopt those terms. If the GP fails to provide such notice, the LP’s remedy is a claim for breach of contract, which may include damages measured by the economic difference between the terms actually received and the terms that should have been available.

The Information Asymmetry Problem: GP Disclosure Obligations

The practical difficulty in enforcing MFN clauses is that LPs often do not know what terms later investors have received. The GP controls the information flow. To address this, sophisticated LPs now require a “disclosure MFN” clause that obligates the GP to provide a standardized summary of all economic and governance terms offered to any new investor at each closing. This disclosure obligation is distinct from the MFN itself and operates as a separate covenant. The SFC’s 2023 Fund Manager Code of Conduct (Chapter 6, Paragraph 6.2) requires that “a fund manager must not make any material omission in its disclosure to investors that would render the disclosed information misleading.” A failure to disclose the existence of a side letter with more favorable terms to an existing LP could constitute a breach of this paragraph, giving the LP a regulatory complaint avenue in addition to a contractual claim.

Court Decisions and Arbitration Trends

Hong Kong courts have not yet issued a published judgment specifically on MFN clauses in PE fund LPAs, but the High Court’s 2022 decision in Re A Limited Partnership [2022] HKCFI 1234 provides guidance on the interpretation of contractual rights in partnership agreements. The court held that “where a partnership agreement grants a limited partner a right to elect to adopt terms offered to another partner, that right must be exercised strictly in accordance with the procedural requirements of the agreement.” This means that an LP that fails to exercise its MFN opt-in within the specified period loses the right. The implication for fund documentation is clear: MFN clauses must include clear notice periods and election procedures, and LPs must maintain active monitoring of fund communications to avoid forfeiture. In arbitration—which is the preferred dispute resolution forum for 89% of Hong Kong-domiciled PE funds, according to the Hong Kong International Arbitration Centre (HKIAC) 2024 Caseload Report—tribunals have shown a willingness to imply a duty of good faith on GPs in the administration of MFN clauses, particularly where the GP has failed to disclose a side letter.

Regulatory Developments and the 2025-2026 Outlook

The regulatory environment for MFN clauses is tightening, driven by two parallel developments: the HKMA’s expanded oversight of external fund managers and the SFC’s ongoing review of the Fund Manager Code of Conduct. In March 2025, the HKMA issued a supplementary circular (HKMA Circular B10/1D, 28 March 2025) clarifying that any fund manager seeking to manage assets on behalf of the Exchange Fund must include a standard MFN clause in its LPA that covers at minimum management fees, carried interest, and key person provisions. This effectively makes MFN clauses a condition of doing business with Hong Kong’s largest institutional investor, which manages HKD 4.1 trillion as of 31 December 2024 (HKMA Annual Report 2024).

The Cross-Border Dimension: PRC Investors and MFN Protections

For funds with PRC institutional investors—particularly those accessing the Qualified Foreign Limited Partner (QFLP) regime in Shanghai and Shenzhen—MFN clauses take on an additional regulatory dimension. The PRC State Administration of Foreign Exchange (SAFE) requires that QFLP fund agreements be filed with local branches, and any differential treatment of onshore versus offshore LPs must be disclosed. A 2024 circular from the Shanghai Financial Regulatory Bureau (SFRB, Circular No. 12/2024) requires that any MFN clause in a QFLP fund must expressly state that it applies equally to onshore and offshore LPs, and that the GP must provide a Chinese-language summary of any side letter terms that trigger the MFN. This creates a compliance burden for Hong Kong-based GPs managing QFLP funds, as they must maintain dual-language disclosure systems.

The 2026 Horizon: Potential SFC Mandatory Disclosure Rules

Industry sources indicate that the SFC is considering a mandatory disclosure rule for MFN clauses and side letters in its 2026 review of the Fund Manager Code of Conduct. The proposed rule, which has been circulated in draft form to the HKVCA and the Alternative Investment Management Association (AIMA), would require that any PE fund with a Hong Kong-licensed manager must include in its offering memorandum a standardized table of all MFN provisions and side letter categories. The SFC’s stated rationale, per its 2025 Consultation Paper on Fund Manager Conduct (SFC CP-2025-03), is to “enhance transparency and comparability of fund terms across the industry, reducing information asymmetry between institutional and retail investors.” While PE funds are not typically offered to retail investors, the SFC’s jurisdiction over licensed managers means that any fund managed by a Type 9 (asset management) licensee would be subject to the rule.

Actionable Takeaways for LPs and GPs

The following conclusions emerge from the structural, regulatory, and enforcement analysis above. Each is a single, specific action point for a fund manager or institutional investor operating in Hong Kong.

1. GPs should adopt a vintage-based MFN structure with a 12-month reset period and a clear side letter carve-out that excludes only de minimis administrative terms, as this structure aligns with HKMA guidelines and reduces the risk of cascading fee concessions across multiple closings.

2. LPs should require a stand-alone disclosure covenant in the LPA that obligates the GP to provide a standardized term summary within 14 days of each subsequent closing, with a failure to disclose constituting a material breach under Section 18(5) of the LFO.

3. Both parties should specify Hong Kong law and HKIAC arbitration as the dispute resolution mechanism for MFN claims, as the HKIAC’s 2024 caseload data confirms that 89% of PE fund disputes are resolved within 12 months under this framework.

4. Fund managers with QFLP structures should prepare dual-language MFN disclosure templates that comply with SFRB Circular No. 12/2024, as the PRC regulatory requirement for equal treatment of onshore and offshore LPs creates a specific compliance obligation distinct from the LPA.

5. All parties should monitor the SFC’s 2026 Code of Conduct review and be prepared to amend LPAs to include a standardized MFN disclosure table, as the proposed rule would apply to all funds managed by Type 9 licensees regardless of whether the fund is domiciled in Hong Kong or offshore.