Early-stage and institutional investors in hedge funds often negotiate preferential terms for themselves. In most cases, the hedge fund manager will not want to share these terms with the other investors. Since an investment in a hedge fund is governed by the fund's underlying corporate documents, an early-stage or institutional investor's preferential terms must be addressed in a supplemental written agreement. This agreement is commonly referred to as a `side letter.' A side letter only modifies the rights of the investor that executes the side letter: other investors in the hedge fund do not benefit from it.

A hedge fund manager may employ certain techniques or trade certain instruments that an investor does not find desirable. However, rather than forego making the investment in the hedge fund, the prospective investor, through the use of a side letter, may seek to limit the manager's strategy in one of four ways:

1. Prohibiting the use of the undesired techniques or the trading of such instruments
2. Limiting the use of the techniques or the trading of such instruments to a certain percentage threshold of the fund's assets (for example, no more than 5% of the fund's portfolio is permitted to be invested in illiquid securities or a single issuer of a security)
3. Requiring the manager to notify the investor prior to reaching a predetermined threshold and allowing the investor to withdraw their assets on an expedited basis
4. Providing the investor with the right to opt out of certain unwanted investments.

Through the use of a side letter, an investor may require the hedge fund manager to reduce the incentive and management fees charged on their investment. The discount provided will depend in large part upon:

• The aggregate assets invested by the investor
• The manager's capacity for managing assets
• The manager's need for such an investment.

Additionally, a side letter may specify the types of expenses that can be charged to the hedge fund, as well as impose a limit on the amount of expenses in the aggregate that can be charged as an operating expense of the fund, stated as a percentage of assets under management.

The term 'capacity constraint' refers to the maximum amount of assets that a hedge fund manager is able to manage effectively, utilising their investment strategy. A hedge fund's capacity depends upon the resources of its manager and the strategy it employs. An investor will, through the use of a side letter, often require a manager to provide the investor with access to a pre-determined amount of a fund's capacity in excess of the latter's initial investment. Nonetheless, the investor may still invest additionalassets in excess of the capacity they have been guaranteed. Managers usually resist guaranteeing significant capacity for any single investor because there is an increased risk that a large withdrawal by such an investor can have a negative impact on the fund's portfolio.

As the use of side letters has become more common, investors have sought to protect themselves from less favourable terms or conditions than those provided to other investors. To that end, an investor will often request, through the use of a side letter, that the manager provide a 'most favoured nation' guarantee, which ensures no other investors have received or will be offered better terms or conditions, unless those terms are offered to the investor in question.

Side letters often contain provisions eliminating or reducing the limitations placed on an investor's redemption of assets from the hedge fund. Such amendments may include eliminating a lock-up, reducing the size of the hold-back (the term 'hold-back refers to a percentage of the amount redeemed which is not returned to the investor until after a specified period of time), or reducing the amount of time the investor is required to provide notice to the hedge fund in connection with a redemption.

In the event that a hedge fund manager is principally owned or controlled by one (or more) key person(s), the fund's success will depend, in particular, on the skill and acumen of the key person(s). If the key person(s) should die, become disabled or otherwise cease to participate in the fund's business, the manager's abilities could be severely impaired. If a key-man provision is not present in the hedge fund's corporate documents, an investor may request that a key-man provision be included in a side letter as an attempt to protect themselves from this risk. A typical key-man provision provides that if the key man dies, becomes legally incapacitated, or ceases to be involved in the management of the hedge fund for more than 90 consecutive days, the manager will notify the investor who may then quickly redeem their investment.

Side letters also often provide for:

• Additional events that require notice to the investor
• Additional events that trigger expedited redemption
• Transparency of the hedge fund's portfolio
• Redemption proceeds to be paid in cash rather than securities-in-kind.

As hedge funds come under greater pressure to enter into side letter agreements, the following questions and concerns arise:

Do any terms of the side letter result in a breach of fiduciary obligation by the hedge fund's general partner, managing member or board of directors? Fiduciaries to a hedge fund owe an identical obligation to each investor. If the terms of a side letter favour one investor at the expense of another, its effect on fiduciary obligations should be reviewed. If the provisions of the side letter raise concerns in connection with the fiduciary duties owed to other investors, one alternative is to create a separately managed account for the investor who is requesting terms different to those offered by the fund.

How many side letters have been entered into? Who is keeping track of the terms of each of the side letters? If a hedge fund is subject to the terms of several different side letters, the operation of the fund will be more difficult and there is a greater likelihood that certain terms of those side letters will be violated. Does the increased demand for side letters indicate that the hedge fund's offering documents are too one-sided? A manager should attempt to address investors' genuine concerns in an organised and comprehensive manner, such as building common side-letter items into the corporate documents. Do the fund's offering documents disclose that certain investors have received preferential terms?