Side-Letter Use Varies Widely By Investor Type, New Study Says

Sep 26 2016 | 6:45pm ET

Investor use of side letter arrangements when investing in hedge funds varies widely, according to a new study by law firm Seward & Kissel billed as the first of its kind to look at the use of the controversial special agreements hedge fund managers occasionally make with certain investors. 

The analysis revealed that funds-of-funds entered into side letters six times as often as non-profit institutions and nearly four times as often as corporate pension funds, the firm said in a statement. The study analyzed side letters extended from hedge fund managers who have been in business for at least two years. Average AUM of the managers was $4.5 billion. 

Specifically, hedge funds in the study entered into side letters most frequently with funds-of-funds, making up 30.5% of all side letter investors, while government plans made up 27.1%. Conversely, investors with the fewest side letters were corporate pensions and non-profit institutions, making up only 8.5% and 5% of all side letter investors, respectively, the study showed. 

Other key highlights from Seward & Kissel’s Hedge Fund Side Letter Study

  • The most common side letter business term was the most favored nations (MFN) clause, which appeared in 56% of all side letters included in the study. Nearly 90% of side letters with wealthy individuals, family offices, and endowments included MFN clauses. However, they were less frequent in side letters signed with funds-of-funds and non-profit institutions, appearing only 33% of the time.
  • 97% of MFNs contained a bundling concept providing that if a preferential term is given to another investor contingent upon a less favorable term, the MFN holder would have to accept the bundle of rights, and cannot select just the favorable term.
  • After MFNs, the second most common side letter term involved fee discounts, which were present in approximately 40% of side letters included in the study, but in only 20% with managers over $1 billion in AUM. 
  • Only one half of the side letters that included fee discounts gave them on both the management fee and the incentive allocation.
  • Managers with at least $1 billion in AUM were much less willing to give fee discounts
  • Only 6.8% of side letters offered preferential liquidity, and none of those were with managers having more than $1 billion in AUM.

“The Seward & Kissel 2015/16 Hedge Fund Side Letter Study gives us insight into an important aspect of the hedge fund industry that hasn’t been subject to this type of analysis before,” said Steve Nadel, partner at Seward & Kissel and lead author of the study. “The disparity in the number of side letters extended to different investor types and the frequency of the business terms given are among the eye-opening findings of this initial study.” 

Founded in 1890, Seward & Kissel LLP is a major U.S. law firm particularly well known for its hedge fund and alternative investment management expertise. It was involved in the establishment of A.W. Jones, widely considered to be the first hedge fund, in 1949.

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