Essential Guide to Hedge Fund Side Letters

Introduction

Investors proposing to make substantial allocations to hedge funds frequently seek to negotiate special terms for their investment by way of a side letter. Side letters contain legally binding representations and commitments from one or more parties connected with the fund in question.

Our recent surveys of hedge fund side letters show that their use is not limited to a particular investor type. We see a wide range of categories of investor negotiating side letters when investing in hedge funds. These include funds of funds, endowments, pension plans, sovereign wealth funds and family offices from across the world.

Investors will seek to sign up a side letter for various reasons including to document the economic deal they have negotiated with the fund manager, to address legal, tax and regulatory issues applicable to the investor and to record ongoing information requirements for the investor to monitor its investment.

In this note, we look into common side letter terms, discuss practical considerations for a manager when reviewing a side letter and provide guidance on how managers can avoid signing problematic side letters.

Common side letter terms

Most favoured nation (MFN)

MFN clauses are amongst the most frequently occurring type of provision in hedge fund side letters. An MFN clause is a commitment to an investor that they are receiving, and will continue to receive, the best terms available to any other investor in a fund or across a group of related products.

In many cases, it will be possible to agree that rights granted to certain other investors will be excluded from the MFN commitment – for example, rights granted to another investor with a larger investment in the fund.

It is also common to see that the types of right covered by the MFN clause are limited to one or more of fees, liquidity and/or information rights. These restrictions can help funds and fund managers manage their compliance with commitments to various MFN investors – as to which see further under “Practical considerations” below.

Fee discounts

A side letter may contain a commitment to charge a reduced management fee and/or performance/incentive fee. This will be particularly common where the investor is investing in a fund vehicle structured as a partnership.

Where the investor is instead investing in shares in a corporate fund vehicle, it will be more common for reduced fees to be structured through investing in a share class to which a lower fee is applied. This will not require a fee discount provision in a side letter.

The alternative structure of operating fee reductions through rebates paid by the fund manager is less popular with investors and managers primarily for administrative reasons. However, where fee rebates are agreed, these will typically be documented in a side letter.

Transparency and risk reporting

Some investors will seek regular reporting on portfolio positions, or higher level “risk reporting”, in prescribed formats. The details of any agreed reporting can be detailed in a side letter.

Although investors will sometimes submit requests for what look like very bespoke reporting requirements, it is always worth checking if the manager’s standard reporting pack will sufficiently deal with an investor’s requirements.

Managers will typically strongly resist giving privileged access to details of the fund’s actual positions to one investor in the fund. We have noticed in our recent surveys of hedge fund side letters how infrequently commitments to provide full portfolio transparency are given, even on a time-lagged basis.

Enhanced liquidity

Draft side letters may contain various provisions attempting to enhance an investor’s ability to redeem from the fund as compared with the redemption terms set out in the fund’s offering document. Examples include requests for the fund to:

• accept shorter notice of redemption
• permit additional redemption days
• disapply one or more redemption restrictions (e.g. a suspension or gating power).

Although frequently requested, we often find these either strongly resisted by the investment manager/fund or negotiated into additional liquidity opportunities (or reductions in redemption restrictions) from which all investors can benefit - not just the investor seeking the side letter. Depending on the investment strategy, granting enhanced liquidity rights to only one investor can present difficulties in the context of a fund board’s fiduciary duties – see “Practical considerations” below.

Capacity rights

Any right for an investor, or related entities, to have capacity retained to invest further amounts in a fund will need recording in a side letter. This is most relevant to strategies which are by nature capacity-constrained. Managers of funds with capacity-constrained strategies will either not want to grant capacity rights or will seek to attach restrictions including expiry dates and/or minimum fees applying to the additional investments.

Notification of events

Side letters also typically contain obligations for the fund and/or fund manager to notify an investor of any specific event not already covered in the fund offering document. Common notification obligations include:

• regulatory action against a party related to the fund
• notice of proceedings against a party related to the fund
• key person event (e.g. changes to the portfolio management team) where not covered in the fund offering document
• changes to one or more fund service providers
• material amendments to the fund offering and constitutional documents.

Portfolio exclusions

Investors may seek restrictions on certain types of investment (for example, investments in companies in a particular industry sector) – either as a hard exclusion or as a right to be notified prior to any such investment being made. There are some signs that this is an increasing area of interest for investors. See “Practical considerations” of excluding investments for one investor below.

Other provisions

There are various other common side letter provisions including transfer rights (where an investor seeks the ability to transfer its investment to other connected entities without further restriction) and co-investment rights (where an investor seeks the right to participate in co-investment opportunities alongside the fund). Investors also often request a range of legal, tax and regulatory representations based on their detailed circumstances.

As with all the provisions of a proposed side letter, these terms will require a detailed review as described further below.

Practical considerations

Conflict with fund governing documents

A review of a proposed side letter should always consider whether any provision conflicts with the provisions of the Articles or other constitutional document of the fund entity. One area where this might arise is where an investor seeks clarifications in the side letter on the operation of redemptions from the fund and related restrictions, such as gates and suspension powers. Any relevant provisions of the side letter cannot contradict the provisions in the Articles or equivalent document. (See also “Approval by fund governing body” for provisions that limit powers of the fund governing body.)

Appropriate allocation of obligations between entities

Each commitment under a side letter should be allocated appropriately between the relevant parties.

For example, an enhanced liquidity provision should typically be given by the fund entity – with additional analysis required in master-feeder structures. A key person notification about the portfolio management team can be given by the fund manager. With an MFN commitment, an investor is likely to want both the fund entity and the fund manager as parties.

Investors should also be concerned to ensure that side letter obligations are properly allocated. They could otherwise have problems enforcing the provisions of the side letter.

Consequences of other MFN commitments

Where there are already other investors with MFN rights, the grant of a side letter to a new investor may trigger notification and other obligations owed to the existing MFN investors. This should be checked before the new side letter is signed.

Two practical steps that can be taken to help manage the related issues and avoid breaching MFN obligations are:

• the keeping of a central record of side letters to assist the review of future side letters and the ongoing compliance with obligations created under them
• seeking to use template language across relevant provisions of all side letters (to avoid having to compare two or more differently worded clauses to decide whether one MFN investor has received better terms than another)

Fund governing body approval

Where a side letter has a fund entity structured as a company as a party, the fund’s board will need to approve the entering into of the side letter. In giving approval, the fund board will need to consider the fiduciary and other duties to which they are subject, including amongst others, any duty to act in good faith in the best interests of the company. In practice, it will be difficult for a fund board to justify approving a side letter provision which commits the fund not to use a power under the Articles (e.g. suspension of redemptions) or to take any other course of action which could have a negative impact for other shareholders.

Similar issues will apply to fund governing bodies of other types of fund entity.

Portfolio exclusions

Where an investor seeks to have exposure to particular investment types excluded from their investment in the fund, consideration needs to be given as to how this will be achieved as part of the fund’s structure. In a corporate fund structure, the investor will as a minimum need to be issued with a separate class of share.

Regulatory issues

The principal regulatory issues relevant to side letters issued in respect of investments in a non-EU domiciled hedge fund managed by a UK manager are considered below.

As a general point, the terms agreed of a side letter should be reviewed for consistency with the UK manager’s regulatory responsibilities as an AIFM or MiFID firm; the UK manager cannot contract out of its regulatory obligations. And, where the UK manager is the AIFM of the fund, it will also need to consider the following specific rules on “preferential treatment”:
a. not to “allow any investor in an AIF to obtain preferential treatment, unless such treatment is disclosed in the relevant AIF’s instrument constituting the fund”. (In a corporate fund, this would normally mean disclosure in the memorandum and articles of association; however, it is understood that the FCA will also be satisfied with the market practice of disclosure in the fund offering document or a standalone document referred to in the fund offering document.)
b. to ensure that “any preferential treatment accorded by the AIFM to one or more investors shall not result in an overall material disadvantage to other investors”
c. (for an AIF marketed in the UK or an EU member state) to make available to investors before they invest a description of preferential treatment (including the right to such treatment) obtained by an investor, the type of investor who obtained such treatment and (where relevant) the investor’s legal or economic links with the AIFM. Material changes to such description are also required to be made available to investors.

Where the preferential treatment is granted by the fund entity rather than the manager, it will in most circumstances be appropriate to treat such preferential treatment as covered by these requirements.

Where the UK manager provides portfolio management but is not the AIFM of the fund, there are no equivalent detailed requirements under the FCA rules. However, a UK manager in this situation may want to consider providing a similar level of disclosure in order to ensure compliance with the broad principles for FCA-regulated businesses, such as the duty to conduct business with integrity. It will also want to ensure that no provisions of a side letter conflict with the interests of the AIFM as the UK manager’s client. The AIFM of the fund will itself be subject to its own applicable regulatory requirements depending on where it is located and where the fund is marketed.

If the fund is marketed to investors in the US, the UK manager will need to consider its disclosure obligations under section 206 of the Investment Advisers Act and Advisers Act Rule 206(4)-8. These disclosure obligations apply whether or not the manager is a registered investment adviser. On an examination of the investment manager by the SEC, the SEC will routinely request details of side letters. The SEC’s focus will be to determine whether adequate disclosure has been made to investors of special terms, including preferential liquidity terms, granted to one or more investors where the exercise of those rights might cause harm to other investors in the fund. The SEC is also concerned to see disclosure of preferential terms of investors in parallel vehicles and accounts managed alongside the main fund.

To ensure compliance with the above regulatory requirements, a common approach taken by UK managers is to ensure the fund offering document includes broad disclosure of the types of preferential treatment that might be granted to a fund investor while a separate document disclosing the details of actual side letters relevant to a fund is maintained and made available to new and existing investors.

The regulatory issues for a manager based outside the UK may differ but the above illustrates the types of regulatory issue that hedge fund managers everywhere will need to analyse when signing a side letter.

Other manager strategies and approaches

Various strategies and approaches are employed by managers and funds when negotiating side letters to reduce their impact for the manager, the fund and other investors. These may include:

• in master/feeder fund structures, limiting the scope of the side letter to the feeder fund in which the investor is investing
• ensuring any MFN commitment includes so-called “anti-cherry picking” language which will require the MFN investor to decide whether or not to take the whole package of a preferential term received by another investor (not just chosen elements of that package)
• negotiating that an MFN investor will receive notification only of preferential terms (rather than the right to have the same term offered to it).

How to avoid side letter problems

Post-signing problems with side letters are not an uncommon experience for hedge fund managers. These can include dealing with the consequences of accidentally triggered MFN provisions, investor concern about the nature of preferential rights granted to other investors under new side letters or simply provisions that interfere with the manager carrying out the fund’s investment strategy.

The best way of avoiding the risk of these problems is for a manager to operate a policy of not offering side letters and attempting to deal with a prospective investor’s concerns through its responses in the due diligence process. A “no side letter” policy will not, however, always survive contact with the real world. A large investor may, for example, refuse to make an allocation without one.

Where a side letter is required, the manager needs to conduct a multi-layered review of the draft document. This should comprise reviews of:

• Commercial terms and general operational feasibility
• Consistency with fund governing documents
• Allocation of obligations between entities
• Consequences of other MFN commitments
• Fund governing body approval considerations
• Regulatory issues including disclosure

If each level of this review is carried out, a manager can significantly reduce the risk of signing a side letter it comes to regret.

For further information on this topic contact us.