* Vanguard voted in favor of package, citing Tesla's performance

* Fund manger had voted against the arrangement in 2018

* Vanguard owns 7% of Tesla, biggest shareholder after Musk

June 14 (Reuters) - Tesla's largest outside investor Vanguard said it voted in favor of CEO Elon Musk's $56 billion pay package, citing the company's performance, contributing to the passage of the record-setting arrangement on Thursday.

In a note seen by Reuters, Vanguard said it had voted against Musk's compensation package when it was first approved by shareholders in 2018 because of its potential size, which might not have been justified by performance.

But "given the strong alignment of executive pay with shareholder returns since 2018 and the benefits the board asserted related to the motivational value for the CEO in preserving the original deal," Vanguard-advised funds voted for the ratification at Tesla's annual meeting, according to the note.

On Friday, the note will be made available on Vanguard's website to the fund manager's more than 50 million investors.

Vanguard had 232 million Tesla shares as of March 31, or about 7% of the company, second only to the 13% stake held by Musk. While certain externally-managed Vanguard funds vote separately, a Vanguard spokesman said the note's descriptions covered the majority of its funds.

Musk's pay was invalidated by a Delaware judge in January, leading to Thursday's vote. Top proxy advisers and various big investors had lined up against the compensation on concerns including that it was too much money.

Tesla had looked to its big retail shareholder base to help approve Musk's pay and other items including re-electing two directors and shifting the company's incorporation to Texas.

But Vanguard, which has total assets of about $9 trillion, and other big index fund managers were always likely to be key to the vote. Representatives of Vanguard rivals BlackRock and State Street declined to comment about their votes on Thursday.

Tesla on Thursday did not disclose exact voting tallies, which are expected to be revealed in coming days.

In its note, Vanguard said while Musk's pay was "a substantial outlier" among CEOs, Tesla's shareholder return was in the 98th percentile of all Russell 3000 companies from 2018 through 2023. "There are few companies that have created as much absolute market value appreciation as Tesla," Vanguard said.

Tesla's performance has sagged in more recent periods including a share price decline of 26.5% so far this year against stiffer competition with other electric vehicle makers. Vanguard's note did not address the current performance. The stock closed up 2.9% on Thursday.

Vanguard also said its funds backed the proposal to move Tesla's incorporation to Texas since "we did not note material differences in shareholder rights between the state of Delaware and the state of Texas."

Thursday's approval does not resolve a lawsuit on Musk's pay package in a Delaware court, which some legal experts think could stretch out for months.

(Reporting by Ross Kerber; Editing by Jamie Freed)