The Use of Side Letters in Hedge Funds

All investors are equal, but some investors are more equal than others

Glenn Kennedy

The use of side letters by hedge fund investors appears to be becoming increasingly common, especially amongst institutional investors, fund of hedge funds and pension funds – exactly the profile of investor hedge funds are most keen to attract. But the increasing prevalence of side letters is not without its risks, especially for hedge fund directors, general partners and investment managers.

This examines side letters in the hedge fund industry, their use, common provisions in side letters (noting the especially problematic ones), and offers a view of where the industry may head as it balances the competing interests of dealing with institutional investors with treating all investors fairly.

Side Letters – what are they and why are they potentially problematic?

For the record, a side letter is generally understood to be a document (typically a letter agreement executed by the investor or potential investor with the hedge fund and/or its investment manager) where the investor seeks to obtain contractually binding assurances from either the hedge fund or its investment manager that modifies the rights and entitlements of that investor. These arrangements may be entered into between the investor and the investment manager only, or with the hedge fund only, or with both the investment manager and the hedge fund.

Views in the industry vary with respect to their risk and also their prevalence. In a recent Wall Street Journal article, Peter Astleford from law firm Dechert LLP, warned that improper side letters are " the industry's ticking time bomb".

While other industry participants, and their lawyers, have resigned themselves to the view that side letters are an inevitable, even necessary, part of the process of dealing with institutional investors and their specific needs, in fact many institutional investors and funds of hedge funds pride themselves on being able to extract more favourable terms from hedge funds by virtue of their size and their 'strategic importance' to any particular fund. Indeed, in terms of their prevalence, it is generally acknowledged that most hedge funds probably have some sort of side letter arrangement with at least one investor.

As one may expect, there are both legal and practical pitfalls in arrangements where particular investors are offered terms that are more favourable or additional to those offered to others. By entering into side letter arrangements hedge funds risk offending the principle that all investors must be treated equally. And, of course, in doing so hedge fund directors and general partners may be neglecting their fiduciary duty owed to investors.

A further potential problem, if not a more practical problem, is one of monitoring adherence to numerous side letters, and in particular, the problem of managing conflicting side letters. For example, a hedge fund will need to ensure that it does not agree terms with one investor that conflict with any undertaking agreed with another investor. Particularly problematic is the 'most favoured nation' clause (see below), where a fund is prohibited from offering terms to other investors that are not also extended to the particular investor concerned.

Accordingly, hedge funds must ensure that side letters are actively monitored, on an on-going basis, to ensure not only that the terms of individual side letters are being tracked but that no conflict arises in different side letters.

And that is not to mention the issue of enforceability of terms contained in side letters, or lack of it. Case law to date is scant. The Cayman Island courts are currently considering an action concerning a side letter, one of the few to be judicially considered, which may in time provide useful guidance for the enforceability (or not) of side letter arrangements.

Common provisions in side letters

What are the common terms of side letters and which ones are potentially problematic to hedge fund directors, general partners, investment managers and investors alike?

Reduced investment management or performance fees or fee rebates. Through the use of side letters, an investor may negotiate reduced management or incentive fees. Typically, these types of side letters are entered into between the investor and the investment manager only (not the hedge fund) and will be structured by way of a fee rebate whereby the investment manager rebates a proportion of its management or incentive fee back to the investor. The extent to which the investment manager will be prepared to negotiate a rebate will typically be dependent upon size of the investment and the manager's need for such investment.

'Most favoured nation' provisions. Perhaps one of the most problematic clauses contained in side letters, and one that has become increasingly common. 'Most favoured nation' clauses are used where investors seek to protect themselves from less favourable terms or conditions than those offered to other current or future investors. An investor may request, in a side letter, that the hedge fund and/or the investment manager provide a most favoured nation guarantee which ensures no other investors have received or will be offered better investment terms unless those terms are offered to the investor in question.

Monitoring side letters with most favoured nation clauses can be particularly problematic and hedge funds and their investment managers must ensure that they do not enter into conflicting arrangements with different investors.

Many side letters are not actively monitored on an on-going basis and the more side letters a fund enters in to, the greater the likelihood certain terms of those side letters conflict.

Preferred liquidity and redemption terms and 'gate' provisions. Side letters often contain provisions reducing or modifying limitations placed on an investor's redemption of assets from a hedge fund. Such modified provisions sometimes include dis-applying a 'lock-up' period or reducing the redemption notice period or dis-applying the 'gate' for certain investors. Other provisions require fund directors to agree up-front that such investor's investment shall not be compulsorily redeemed. All these provisions are becoming increasingly common in side letters yet it is generally agreed that their enforceability is, at best, questionable.

Key Man provisions. In the event that an investment manager is owned or controlled by one or more key persons or if a hedge fund's future success is perceived to be particularly dependent upon those key persons, then an investor may seek to protect themselves against 'key man risk'. A typical key man provision will provide that if the 'key man' ceases to be actively involved in the management of the particular hedge fund for more than a specified number of days then the fund will notify the investor who may then quickly redeem their investment. The length of time varies between side letters but some are as little as 21 days, which has interfered with some investment manager's holiday plans.

Capacity. Some investors may request that a hedge fund and/or its investment manager provide the investor with access to an agreed amount of the fund's capacity in excess of the investor's initial subscription. These provisions may be problematic for a fund where a single investor is granted significant capacity as there is the increased risk that a withdrawal by the investor can negatively impact the portfolio.

Transparency. Some investors request further and more detailed information regarding the composition of the fund's portfolio, its trading activity, the nature of the investments made by the hedge fund or other information to assist the investor with their own 'risk reporting'. Other investors even attempt to guarantee, by way of side letter, access to portfolio managers or other key persons for the purposes of answering queries that the investor may have about the portfolio and its recent trading activities.

Notification events. Some side letters contemplate additional investor notifications and enhanced monitoring for a particular investor. For example, ERISA monitoring and reporting and reporting percentage holdings and monitoring concentration limits of that investor.

What do the regulators think of all of this?

Seemingly, not much. At least not yet… An FSA spokesman, in a recent newspaper article, commented that the FSA doesn't look at investment terms set by hedge funds because the hedge funds themselves are typically domiciled outside its jurisdiction in the UK.

The SEC, meanwhile, in its new registration rules for hedge fund investment advisors was not giving much away either, merely highlighting the use of side letters by hedge funds in a footnote. It has not yet taken any action regarding them. Perhaps ominously, an SEC spokesman said that the agency would be concerned about situations involving inadequate disclosure of side letter arrangements – but more of that below.

Are all side letters bad?

Probably not. Many investors do have bespoke needs or reporting requirements that may not be contemplated by a hedge fund's offering documents. Satisfying those specific requirements often does not adversely impact existing investors nor does it mean that the particular investor is treated preferentially. Disclosure in the fund's offering documentation that side arrangements may be entered in to by either the investment manager or the fund is also becoming common and a step in the right direction. However, while side letters are becoming increasingly prevalent, directors of hedge funds and investment managers should not unquestioningly accept the terms presented to them and should beaware of their potential risks and possible consequences. Specifically, directors and investment managers should be especially mindful of whether or not the side letter will be unfairly advantageous to the particular investor or act to the detriment of existing investors.

In addition, directors and investment managers may also consider whether there are alternatives to entering into side letters or whether there are other ways to satisfy the particular investor's needs while not treating them preferentially to other investors. Alternatives will obviously depend upon the individual circumstances. Some hedge funds have a policy that they will not enter into side letters. Others only agree to terms if they are in a position to and are willing to extend the same terms equally to all other investors. Others create special share classes where the rights attaching to those classes reflect the terms agreed with a particular investor but are available for investment by other existing or potential investors.

Only time will tell whether side letters are the industry's 'ticking time bomb'; however in order to avoid any detonation the industry generally, and hedge fund directors and investment managers particularly, need to strike a proper balance between the demands of (increasingly influential) institutional hedge fund investors with their general responsibility to treat all investors equally.

Glenn Kennedy is Head of Legal at BISYS Hedge Fund Services. BISYS Hedge Fund Services is the largest hedge fund administrator in Europe.