Setting investor concerns aside: A look at hedge fund side letters

The reliance on side letters by the hedge fund industry continues unabated, despite all the upheaval that has challenged manager returns and investor expectations this year. Manager strategies remain the same, but investor needs may be evolving if the bump up in fee discount demands is any indication. This follows a continued trend by many firms to offer managed account access for a number of reasons with an estimated 70% of the separately managed accounts having fee structures not typically offered in a standard hedge fund format, according to law firm Seward & Kissel. Adoption of separately managed accounts still seems to have dipped slightly from past years when it comes to mature hedge funds and funds of hedge funds. Seward & Kissel has been surveying managers and investors regarding their side letter appetites for five years and while they are quick to say that the findings only represent the early days of the pandemic winding down June 30, 2020, the results still are telling of the state of play between hedge funds and their clients. “Consistent with the view that hedge funds tend to be an attractive asset class in times of heightened volatility, we did not see a decrease in side letter activity at the end of the period,” the study authors observed. “Next year’s study will reveal whether the asset class sustained its momentum throughout the pandemic.” According to Kevin Neubauer, a partner in the Investment Management Group at Seward & Kissel and lead author of the study: "Our fifth Side Letter Study has again unearthed valuable insights into the continued evolution of hedge funds and their investors. The Seward & Kissel 2019/2020 Hedge Fund Side Letter Study demonstrates strategic choices being made by hedge fund managers and their investor base alike." What the team uncovered was that the most common user of side letters remains funds of hedge funds, representing 42% of all side letter investors, which is a slight increase from the downward trend the group has uncovered over the past three years of the survey. Side letters with government plans (18%) and corporate pension plans (15%) were the second and third most common investor category of side letter investor, respectively, suggesting that the revived interest in hedge funds by these types of investors first identified in last year’s study has continued, according to Seward & Kissel. All of the side letters with government plans and endowments were with mature managers, while half of the newer manager side letters were with funds of funds. So what are managers agreeing to with these investors? Mostly fee discount clauses, which were included in 46% of all side letters, which is up significantly from 2017/2018 when only 24% of side letters had such wording. Just over half of the fee discount arrangements (53%) covered both management fees and incentive allocations, while 47% applied to one of the fee arrangements only. The fee discount clauses are consistent with Seward & Kissel’s observation of sustained interest from large institutional investors such as government and corporate pension plans, evidencing that these kinds of entities continue to push for fee breaks in their side letters. Most favored nation status or MFN had previously been the most popular side letter agreement, but has slipped in popularity. Preferred liquidity agreements, more common among newer managers, and transparency/reporting obligations of portfolio positions or exposures round out the check list of popular business terms.

Setting investor concerns aside: A look at hedge fund side letters

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