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Hedge funds’ study reveals vast disparity in types of investors securing side letter arrangements

Tuesday, September 27, 2016
Opalesque Industry Update - A new study of the hedge fund space by industry law firm Seward & Kissel LLP reveals a wealth of information regarding established hedge fund managers’ use of side letters—special agreements that hedge fund managers sometimes make with investors, overriding general terms applicable to other investors—including the fact 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 Seward & Kissel 2015/16 Hedge Fund Side Letter Study, a first-of-its-kind analysis released today, shows that hedge funds in the study entered into side letters most frequently with funds-of-funds (making up 30.5% of all side letter investors) and government plans (making up 27.1% of all side letter investors). The investor types 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.

Additionally, 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, MFN clauses were less frequent in side letters signed with funds-of-funds and non-profit institutions, appearing only 33% of the time.

The Seward & Kissel 2015/16 Hedge Fund Side Letter Study analyzed side letters extended from hedge fund managers who have been in business for at least two years, and the average regulatory assets under management (RAUM) of such managers was $4.5 billion. The study’s focus on more mature managers complements the analysis of the hedge fund industry that Seward & Kissel provides through its annual study of newly formed hedge funds (The Seward & Kissel New Hedge Fund Study).

Other significant findings include:

  • 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 RAUM. Moreover, only one half of the side letters that included fee discounts gave them on both the management fee and the incentive allocation.
  • Only 6.8% of side letters offered preferential liquidity, and none of those were with managers having more than $1 billion in RAUM.

“The breadth of our practice continues to provide us with important thought leadership data points,” said Steve Nadel, partner at Seward & Kissel and lead author of the study. “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. 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.”

Seward & Kissel LLP, founded in 1890, is a leading U.S. law firm with an international reputation for excellence. The firm is particularly well known for its hedge fund and investment management work, having established the first hedge fund ever, A.W. Jones, in 1949, and having earned numerous best in class awards over the years.

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