Hedge Fund Side Letters

The side letter is one of the most important items for a hedge fund manager.  While the hedge fund will run pursuant to the terms of the hedge fund offering documents drafted, the side letter will give the manager some flexibility to go outside the terms of the documents for certain investors.

A hedge fund side letter is simply an agreement between the hedge fund manager and the investor that outlines different terms that will apply to the investor’s investment into the fund.  The side letter is drafted by the hedge fund attorney and will be signed by the investor at the same time that the investor signs the hedge fund subscription documents.

Overview of side letter provisions

Below are some of the reasons a hedge fund manager may use a side letter arrangement

Reduced Fees – the hedge fund manager will reduce or waive the management fees or performance fees for the investor.

Lock-up and liquidity – the hedge fund manager may reduce or waive the lock-up for a specific investor.  The manager may also allow for greater liquidity (i.e. monthly withdrawals instead of quarterly withdrawals).

Information – the manager may agree to provide an investor with greater informational rights such as the ability to request a description of the exact positions of the fund at any given time.

Most favored nation’s clause – this allows an investor to get the best deal that the manager gives to any other investor.  This clause is usually reserved for very large or very early investors.

There are many different ways which any of the above concepts can be implemented into the side letter and generally it will depend on the business points negotiated by the manager and the investor.  As an alternative to a hedge fund investment and side letter arrangement, an investor may simply enter into a separately managed account (known as a “SMA”) arrangement with the hedge fund manager.

Side letters and raising money for the hedge fund

The hedge fund side letter can be an important tool for raising assets.  Typically the letter will be used to entice early investors to invest in the fund; it can also be used to attract investors who will contribute a large amount of assets to the fund.  The side letter can also be used to try to get a current investor to contribute more assets to the fund.

What the SEC says about side letters

During the late part of 2007 and the early part of 2008, there was a lot of chatter within the hedge fund industry that the SEC would increase its investigation of hedge fund side letters.  Presumably they would have tried to accomplish this through audits of hedge fund managers registered as investment advisors.  While there was much concern within the industry at the time, that concern has subsided as the market events of 2008 began to take on greater importance.

Testimony from SEC regarding hedge fund side letters

The following comes from testimony by a SEC official to Congress regarding hedge funds and side letters:

Side Letter Agreements. Side letters are agreements that hedge fund advisers enter into with certain investors that give the investors more favorable rights and privileges than other investors receive. Some side letters address matters that raise few concerns, such as the ability to make additional investments, receive treatment as favorable as other investors, or limit management fees and incentives. Others, however, are more troubling because they may involve material conflicts of interest that can harm the interests of other investors. Chief among these types of side letter agreements are those that give certain investors liquidity preferences or provide them with more access to portfolio information. Our examination staff will review side letter agreements and evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.

ERISA considerations

Hedge funds which are ERISA hedge funds will need to be careful about their side letter activities and should always consult with their hedge fund attorney before entering into such arrangements.  Specifically, the Department of Labor is concerned about different informational rights, especially with regard to plans which have subordinated rights.

If you have any questions regarding side letters, please contact us.