Side letter agreements supplementing or modifying the standard terms of a fund’s offering memorandum, subscription agreement or constitutional documents to grant preferential treatment to an individual investor, generally as a precondition of a large investment, often provide a revelatory view into the current market dynamics of the hedge fund industry. In its most recent Hedge Fund Side Letter Study, Seward & Kissel LLP found that the hedge fund industry’s use of side letters has dramatically increased among newer asset managers, funds of funds are the most common side letter investors, and fee discounts and most favored nations clauses are the most frequently negotiated side letter terms.
This article summarizes these and other key findings from the study.
Seward & Kissel surveyed side letter agreements at both mature manager clients—defined as hedge funds in business for two or more years—and newer manager clients operating less than two years. The average RAUM for mature managers was $4.37 billion (based on data culled from firms’ most recent Form ADV filings), and approximately 90% of them were registered with the SEC as investment advisers, with the remainder qualifying as exempt reporting advisers. None of the newer managers in the study were registered with the SEC, and Seward & Kissel estimated that their average RAUM was less than $150 million.
The main investor types that Seward & Kissel found managers consistently negotiated with, in order of frequency, were: funds of funds; wealthy individuals/family offices; government plans; endowments; non-profit institutions; and corporate pensions.
Side Letter Usage Across Manager and Investor Types
Mature managers garnered nearly $83 million in investments via side letters, while new managers averaged $53.65 million. The biggest investments by far came from government plans, with an average investment of $163.4 million, followed by funds of funds at $73 million; non-profit institutions with $47 million; endowments with $40 million; wealthy individuals/family offices with $17 million; and corporate pensions with $10 million.
The study found that funds of funds most frequently negotiated side letters, comprising 56% of all side letter investors, or nearly double the 30.5% of fund of funds the 2015/2016 study found invested via side letters. The average investment size for funds of funds was $81 million to mature managers and $57 million to newer managers.
The second largest investor category was wealthy individuals/family offices, which represented 17% of all side letter investors, compared to 13.5% in 2015/2016. Wealthy individuals/family offices invested an average of $21.6 million with mature managers and about $5 million with newer managers.
Government plans represented the third largest investor category with 14% of all side letter investors, down significantly from 27.1% in Seward & Kissel’s last study, and endowments made up six percent of all side letter investors, compared to 15.2% in 2015/2016. Non-profits, which remained at four percent, and corporate pensions, at three percent, rounded out the side letter investor total.
Notably, the study also found that 100% of side letters negotiated by government pension plans were with mature managers. Wealthy individuals and family offices evenly split their side letter allocations between new and mature managers; they also represent one-third of all side letters with newer managers. Funds of funds represented the other 61% of side letters with newer managers.
Seward & Kissel uncovered other trends as well. First, the statistics highlighted a growing delta between funds of funds and wealthy individuals/family offices, the two investor types most likely to secure side letters. Funds of funds accounted for 56% of all side letters, a significant increase from last year’s 30%, and wealthy individuals/family offices, who represent 17% of side letters, up less than four percent from 2015/2016. All other investor types—endowments, nonprofits, corporate pensions and government plans—collectively accounted for only 27% of all side letters, down from 56% last year.
In addition, the study revealed a sharp rise in side letters agreed to by hedge fund managers in business for less than two years. That rate jumped to 20%, up from 13% last year. Eighty percent of side letters entered into are negotiated with mature managers.
Side Letter Terms
Managers are seeing a lot of pressure on fees, which now are a perennial top term investors seek to negotiate through side letters. Considering this pressure, it is not surprising that fee discounts are the most frequently negotiated term in side letters, with 49% of side letters including such terms.
Of the side letters with fee discount clauses, 65% lowered both the management fee and the incentive allocation, 29% reduced just the management fee and six percent discounted only the incentive allocation. Much like last year’s study, nearly one-third of the side letters including fee discounts conditioned the term on a longer lock-up.
Most Favored Nation Provisions
MFN clauses were seen in 47% of side letters, down from 56% in the 2015/2016 study. Interestingly, each of the side letters that contained MFN clauses did so in connection with a bundling or package concept that stipulated that if a preferential term was given to another investor contingent upon a less favorable term, the MFN holder would have to accept the bundle or package of rights, not just the favorable term.
The third most frequently negotiated term, in approximately 26% of side letters reviewed, was some form of a transparency/reporting obligation. More than two-thirds of transparency/reporting obligation terms involved monthly risk and exposures reporting.
The study only examined side letters with liquidity terms that focused on an investor’s ability to redeem from a fund earlier than other investors, not on other common liquidity-related side letter terms such as clarifications related to gating, in-kind distributions and/or suspension clauses. Although hedge fund managers tend to be reluctant to give out preferential liquidity, and regulators generally do not look favorably upon such terms, preferred liquidity terms appeared in 11.4% of the side letters, nearly twice the 6.8% of side letters with such terms Seward & Kissel found in the previous study.
Because more investors are now investing with managers through separately managed accounts rather than in a commingled hedge fund, the study also tracked SMAs in 2016-17 and found that SMAs were most likely to be executed with funds of funds (69%) and family offices (23%). Additionally, 76.9% of the SMAs were with mature managers and more than 80% of the SMAs had fee structures typically not found in the non-founder classes of hedge funds, such as lower rates, sliding scale rates and/or hurdles on incentive fees.