Hedge Fund Side Letter – 6 Secrets You Need to Know About 

Introduction: Hedge Fund Side Letter

---

About: Hedge Fund Side Letter

Hedge fund side letters, also referred to as side agreements or side arrangements, are individualized contractual agreements between a hedge fund manager and a specific investor or group of investors. These letters exist alongside the main offering documents, such as the fund’s prospectus or private placement memorandum, and are tailored to the unique needs and preferences of the investor(s).

In this document, the investor seeks legally binding assurances from either the hedge fund or its investment manager, which alter the rights and privileges of that specific investor. These arrangements can be established between the investor and the investment manager exclusively, with the hedge fund alone, or with both the investment manager and the hedge fund.

Topic: Hedge Fund Side Letter

---

Why is Hedge Fund Side Letter Used?

Hedge Fund Side letter serve several key purposes for both hedge fund managers and investors. For hedge fund managers, they provide a means to attract and retain significant investments by offering customized terms. For investors, side letters can offer various benefits, such as special fee structures, favorable redemption terms, and enhanced reporting requirements, to meet their specific investment objectives.

---

Key Components of Hedge Fund Side Letter

A Hedge fund side letter typically include the following key components:

Hedge Fund Side Letter

Topic: Hedge Fund Side Letter

Here are various reasons why a hedge fund manager might choose to establish a hedge fund side letter arrangement:

• Fee Reduction: The hedge fund manager might opt to lower or waive the management fees or performance fees for the specific investor.
• Lock-Up and Liquidity: The hedge fund manager may make adjustments to the lock-up period for a particular investor, potentially reducing it. Additionally, the manager may offer more frequent liquidity options, such as monthly withdrawals instead of quarterly ones.
• Enhanced Information Rights: The manager could agree to provide the investor with expanded informational rights, including the ability to request a detailed description of the fund’s positions at any given time.
• Most Favored Nation (MFN) Clause: This clause enables the investor to receive the most favorable terms that the manager extends to any other investor. Typically, this provision is reserved for large or early investors with significant influence.

These concepts can be integrated into a side letter in various ways, depending on the negotiations and specific terms agreed upon by the manager and the investor. As an alternative to investing in a hedge fund with a side letter arrangement, an investor may choose to enter into a separately managed account (SMA) arrangement with the hedge fund manager.

---

The Negotiation Process for Hedge Fund Side Letter

Hedge Fund Side letters are typically negotiated between hedge fund managers and investors with significant investments or unique requirements. The negotiation process involves tailoring the terms to meet the investor’s specific needs, and this customization is a key driver behind the use of side letters.

Topic: Hedge Fund Side Letter

---

Potential Advantages and Concerns

Hedge Fund Side Letters offer advantages such as increased flexibility and the ability to attract larger investments. However, they can also raise concerns about transparency and fairness. Some investors might worry that side letters create preferential treatment and potentially disadvantage others.

---

Case Studies – Is Hedge Fund Side Letter Problematic?

Opinions within the industry differ regarding their level of risk and prevalence. A recent Wall Street Journal article featured Peter Astleford of the law firm Dechert LLP, who cautioned that improper side letters represent a potential crisis within the industry.

In contrast, some industry participants and their legal advisors have come to accept side letters as an unavoidable and even necessary aspect of dealing with institutional investors and their unique requirements. In fact, numerous institutional investors and hedge funds take pride in their ability to negotiate more favorable terms from hedge funds due to their size and perceived “strategic importance.” It’s generally recognized that most hedge funds likely have some form of side letter agreement with at least one investor.

Naturally, there are both legal and practical challenges in situations where certain investors are offered terms that are more advantageous or distinct from those extended to others. Engaging in side letter agreements places hedge funds at risk of violating the fundamental principle that all investors must be treated equitably. Furthermore, hedge fund directors and general partners may be neglecting their fiduciary duty to investors by doing so.

Topic: Hedge Fund Side Letter

Another potential issue, if not a more practical one, is the need to oversee compliance with numerous side letters, particularly the management of conflicting side letters. For instance, a hedge fund must ensure that it does not agree to terms with one investor that contradict undertakings made to another investor. The ‘most favored nation’ clause, which prohibits the fund from offering terms to one investor that are not also offered to other investors, can be particularly problematic.

Hence, hedge funds must actively monitor side letters on an ongoing basis, ensuring not only that the terms of individual side letters are being monitored but also that no conflicts arise among different side letters.

Lastly, there is the issue of the enforceability, or lack thereof, of the terms contained in side letters. Case law on this matter is limited. The Cayman Islands courts are currently reviewing an action involving a side letter, which is one of the few instances to be judicially considered and may provide useful guidance on the enforceability of side letter arrangements in the future.

---

Topic: Hedge Fund Side Letter

Regulatory and Industry Oversight

Regulators and industry organizations play a role in overseeing the use of side letters to ensure they don’t create unfair advantages or lead to misconduct. It’s important to stay informed about any changes or developments in regulations related to side letters.

So far, it appears that there hasn’t been much scrutiny on this matter. A recent newspaper article quoted an FSA spokesperson who mentioned that the FSA doesn’t typically examine the investment terms established by hedge funds. This is primarily because hedge funds are usually located outside of the FSA’s jurisdiction in the UK.

On the other side of the Atlantic, the SEC, in its recent registration rules for hedge fund investment advisors, did not provide extensive details either. They briefly acknowledged the use of side letters by hedge funds in a footnote but have not taken any concrete actions as of yet. It’s worth noting that an SEC spokesperson mentioned the agency’s concern about situations involving insufficient disclosure of side letter arrangements, but we will delve deeper into that topic below.

---

Are all Hedge Fund Side Letters bad?

Topic: Hedge Fund Side Letter

Are all side letters inherently problematic? Probably not. Many investors have unique needs or reporting requirements that may not be covered by a hedge fund’s standard offering documents. Fulfilling these specific requirements typically does not have a negative impact on existing investors, nor does it imply preferential treatment of the particular investor. It’s worth noting that disclosure in the fund’s offering documentation about the potential use of side arrangements by either the investment manager or the fund is becoming more common, which is a positive step.

Topic: Hedge Fund Side Letter

However, even as side letters become more prevalent, hedge fund directors and investment managers should not automatically accept the terms presented to them. They should be mindful of the potential risks and consequences. In particular, directors and investment managers should consider whether the side letter could unfairly benefit the specific investor at the expense of existing investors.

Furthermore, directors and investment managers should explore whether there are alternatives to entering into side letters or if there are other ways to meet the specific investor’s needs without providing preferential treatment. The suitability of alternatives will depend on individual circumstances. Some hedge funds have policies against entering into side letters. Others agree to terms only if they can extend them equally to all other investors. Some create special share classes that reflect the terms agreed upon with a particular investor but are open for investment by other existing or potential investors.

Topic: Hedge Fund Side Letter

Ultimately, whether side letters become an industry concern remains to be seen. To avoid potential issues, the industry as a whole, and hedge fund directors and investment managers in particular, must strike a proper balance between meeting the demands of increasingly influential institutional hedge fund investors and their overarching responsibility to treat all investors fairly.

---

Investors’ Use of Side Letters

Topic: Hedge Fund Side Letter

Do all side letters have negative implications? Not necessarily. In the hedge fund landscape, early-stage and institutional investors often negotiate terms that are more favorable to their specific requirements. These terms are usually not shared with other investors. Since investments in hedge funds are governed by the fund’s underlying corporate documents, any preferential terms for early-stage or institutional investors must be outlined in a supplementary written agreement, commonly known as a ‘side letter.’

It’s important to note that a side letter only amends the rights of the investor who enters into it, and other investors in the hedge fund do not benefit from its provisions.

Hedge fund managers may employ techniques or trade instruments that are not appealing to a particular investor. Rather than forgoing their investment, prospective investors, through the use of side letters, may seek to restrict the manager’s strategy in one of the following four ways:

1. Prohibiting the use of undesirable techniques or the trading of such instruments.
2. Limiting the use of these techniques or trading to a specific percentage threshold of the fund’s assets (for example, no more than 5% of the fund’s portfolio can be invested in illiquid securities or a single issuer of a security).
3. Requiring the manager to notify the investor before reaching a predetermined threshold, allowing the investor to withdraw their assets quickly.
4. Granting the investor the right to opt out of certain undesired investments.

Topic: Hedge Fund Side Letter

Through side letters, an investor can also negotiate with the hedge fund manager to reduce the incentive and management fees charged on their investment. The extent of the discount provided often depends on factors such as:

• The total assets invested by the investor.
• The manager’s capacity to handle assets.
• The manager’s need for such an investment.

Furthermore, a side letter may define the types of expenses that can be charged to the hedge fund and set a limit on the aggregate amount of expenses that can be charged as an operating expense, stated as a percentage of assets under management.

The term ‘capacity constraint’ refers to the maximum assets that a hedge fund manager can effectively manage using their investment strategy. A hedge fund’s capacity is influenced by the manager’s resources and strategy. Through a side letter, an investor often requests access to a predetermined amount of a fund’s capacity beyond their initial investment. Nevertheless, the investor may still choose to invest additional assets beyond the guaranteed capacity. Managers typically resist guaranteeing significant capacity to a single investor because a large withdrawal by such an investor could negatively affect the fund’s portfolio.

As the use of side letters has become more common, investors seek to protect themselves from less favorable terms or conditions than those offered to other investors. In this regard, an investor often requests a ‘most favored nation’ guarantee from the manager through a side letter. This guarantee ensures that no other investors have received or will receive better terms or conditions unless the same terms are offered to the investor in question.

Side letters often contain provisions that eliminate or reduce limitations on an investor’s ability to redeem assets from the hedge fund. These modifications may include eliminating a lock-up period, reducing the size of the hold-back (a percentage of the redeemed amount that is withheld until a specified period has elapsed), or shortening the notice period required for redemption.

Topic: Hedge Fund Side Letter

In cases where a hedge fund manager is primarily owned or controlled by one or more key individuals, the success of the fund may heavily rely on the expertise and involvement of these key figures. If a key-man provision is not present in the hedge fund’s corporate documents, an investor may request the inclusion of such a provision in a side letter to safeguard against the risk of the manager’s capabilities being severely impaired due to the key individual’s death, incapacity, or cessation of involvement in the fund’s management.

A typical key-man provision stipulates that if the key individual dies, becomes legally incapacitated, or ceases to be involved in the fund’s management for more than 90 consecutive days, the manager will notify the investor, who may then promptly redeem their investment.

Additionally, side letters may include provisions for:

• Notifying the investor about additional events.
• Triggering expedited redemption under specific circumstances.
• Providing transparency regarding the hedge fund’s portfolio.
• Requiring that redemption proceeds be paid in cash instead of securities-in-kind.

Topic: Hedge Fund Side Letter

---

Cross-Questioning about Hedge Fund Side Letter

As hedge funds face increasing pressure to enter into side letter agreements, certain questions and concerns come to the forefront:

1. Do any terms of the side letter breach the fiduciary obligations of the hedge fund’s general partner, managing member, or board of directors? Fiduciaries to a hedge fund owe the same obligation to each investor. If the side letter’s terms favor one investor at the expense of others, it may raise concerns about their impact on fiduciary duties. In such cases, one alternative is to establish a separately managed account for the investor requesting terms that differ from those offered by the fund.
2. How many side letters have been executed? Who is responsible for monitoring the terms of each side letter? When a hedge fund is subject to various side letters with distinct terms, managing the fund becomes more complex, and there is a greater likelihood of breaching some of the side letter terms. The increased demand for side letters may also suggest that the fund’s offering documents are perceived as favoring one side excessively. Managers should address genuine investor concerns in a structured and comprehensive manner, such as incorporating common side-letter provisions into the corporate documents.
3. Do the fund’s offering documents disclose that certain investors have received preferential terms?

Topic: Hedge Fund Side Letter

---

Topic: Hedge Fund Side Letter

---

Checkout this Video on Hedge Fund Side Letter by Dechert LLP