In the world of hedge funds, the rights, opportunities, fees and, most importantly, information available to one investor
may look completely different than those available to another in the same fund. The documents that outline these special privileges are called hedge fund side letters, and not being aware of the ones associated with your investments could hurt you.
“Hedge fund side letters are agreements that provide certain investors with more favorable terms than those offered in the fund’s standard offering documents,” says Rebecca Edwards, a corporate attorney in the corporate practice group with the Chicago law firm of Levenfeld Pearlstein LLC. “For example, side letters may provide certain investors with lower management fees, more frequent opportunities to withdraw their investments from the fund, and enhanced or early information regarding the management or investments of the fund.”
Smart Business discussed with Edwards the impact of hedge fund side letters on investors, current regulations in the industry and how to best protect your interests.
How can side letters affect hedge fund investors?
Regulators are concerned that side letters can enable certain investors that are better informed to exit the fund ahead of others when the fund is not performing well. Additionally, side letters may provide certain investors with better investment returns if the management fees paid by such investors are lower.
What type of disclosures do managers usually provide investors?
Often hedge fund offering documents simply disclose that the fund has the ability to enter into side letters with investors. If possible, investors should request copies from the fund of any specific side letters. This helps interested parties to evaluate their potential risk if other members of the fund choose to exercise their special privileges.
Regulators have taken the position that managers should disclose side letters to investors or create a separate class of interests if such side letters promote unequal treatment of investors. This separate class of interests could justify why such investors are being treated differently. However, hedge fund managers may not follow these guidelines so investors still need to investigate the existence of side letters to ensure they have a clear understanding of their investment situation.
What SEC regulations pertain to side letters?
There are no SEC regulations that specifically pertain to side letters. In fact, because hedge fund managers are not usually required to register with the SEC, hedge fund investors generally do not receive all of the federal and state law protections that commonly apply to most registered investments.
Attempts by the SEC to require hedge fund managers to register with the Investment Advisers Act by the SEC have been thwarted. In June 2006, the court in Goldstein v. SEC overturned the SEC’s manager registration rule and sent it back to the SEC for review. This means hedge fund investors need to take more personal responsibility for confirming that investment decisions are made in their best interest.
How can investors become more aware of relevant conflicts of interests?
Conflicts of interest are common in the management of hedge funds. Investors should make sure that the offering documents disclose conflicts of interest and look for funds offering documents that disclose the funds’ ability to enter into side letters. At the outset of the process, investors should have all of these disclosures evaluated by an experienced attorney. Investors should also research the scope of the manager’s activities, including what other funds the individual manages and what outside business activities fall under this person’s supervision.
Are there any new legal developments with side letters?
Although there are no new regulatory developments in the United States, the Alternative Investment Management Association (AIMA), a United Kingdom trade association, issued guidance regarding side letter disclosure standards in 2006. This guidance assists firms in complying with U.K. Financial Services Authority (FSA) requirements.
The FSA stated that it expects hedge fund managers to ensure that all investors understand that a side letter has been granted and that conflicts may arise in Feedback Statement FS06/2. In response, AIMA further provided that investment advisers should disclose the existence of side letters that contain ‘material terms’ and the nature of any such terms. A ‘material term,’ as defined by AIMA, includes any term that is reasonably expected to put other shareholders at a material disadvantage. Examples include grants of preferential exit rights, giving certain investors portfolio transparency rights, ‘key man’ provisions, and percentage of investor holdings where grants go to investors owning more than 10 percent of the fund.
REBECCA EDWARDS is a corporate attorney in the corporate practice group with the Chicago law firm of Levenfeld Pearlstein LLC. Reach her at (312) 476-7588 or firstname.lastname@example.org.