New York-based law firm Seward & Kissel found that while pensions and other end investors relied on mature managers, fund of hedge fund firms picked up the pace in engaging with new managers following the due diligence challenges brought on by the pandemic.
The Seward & Kissel 2020/2021 Hedge Fund Side Letter Study showed increasing side letter activity despite the pandemic with investors allocating mostly to mature managers whose AUM averaged $6.3 billion. They also engaged with newer managers with less than two years’ experience.
The study was the law firm’s sixth annual analysis of hedge fund side letters. They found that fund of hedge funds, accounting for 54% of all side letters, reaching their highest level since 2017/2018. Endowments were the second most prevalent side letter investor followed by government plans.
Mature managers accounted for 79% of the side letters in the study. Seward & Kissel noted that there appears to be sustained interest from government plans and corporate pension plans. All of the side letters from pensions were with mature managers, while 78% of newer manager side letters were with funds of funds.
According to Seward & Kissel Partner Kevin Neubauer, the hedge fund industry has “retained a certain level of vibrancy, with strategic choices by managers and their investor base seeming to demonstrate confidence in smaller, newer managers and their ability to be nimble in their investments as well as, unsurprisingly, favoring familiarity and experience with a continued strong interest in larger established managers.”
Side letter agreements traditionally address a wide array of investor concerns. Seward & Kissel in its survey focused on five business terms: most favored nations protection or MFN clause; fee discounts; preferred liquidity; transparency/reporting obligations; and capacity rights for the first-time investors.
The study follows a similar survey on the use of separately managed accounts. The SMA Snapshot Report found that 45% of SMAs had managers deviating from the investment strategy of their flagship hedge funds to accommodate investor mandates around ESG considerations, exposure to private investments, cryptocurrency or other digital assets.
Looking closely at side letter contents, officials noted that most (43%) deal with fee discounts — a jump from 2017/2018 when fees made up 24% of all side letters. This specific term was most common in newer manager side letters (67%) than in mature manager side letters (29%).
Fees though were tied with MFN clauses as the most common side letter request at 43%. These clauses stipulate that if a preferential term such as a lower fee was given to another investor contingent upon a less favorable term such as a longer lock-up period that the MFN holder would have to accept the bundle or package of rights and could not just select the favorable term.
