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Most investors contemplating investing in a hedge
fund believe they are presented with a set of fixed terms for
their investment. These terms are outlined in the private offering memorandum
and appear to apply across the board to all investors. However, careful
readers of the offering memo as well as the publicly available registration
form (ADV) can ferret out what is often true - that some investors may be
subject to more favorable terms. These terms are agreed upon in a "side
letter" prior to investment and are usually granted to large or important
investors, such as seed investors.
Once thought to be innocuous, if not actually beneficial
to a hedge fund, side letters are turning out to be the bain of many managers'
operations. Raising issues ranging from the mundane (housekeeping) to
headline-making (SEC regulatory actions), many managers are now thinking twice
before granting special terms in a side letter.
Some of the more common issues with side letter usage
1. Inadequate disclosure of preferential treatment - This
is the area in which regulators may get involved. The most
recent example of this is the possible pending SEC case against Philip
Falcone's Harbinger Capital Partners which appears to revolve around
the granting of preferential redemption rights to certain investors under the
terms of a side letter. Managers granting better treatment to side letter
investors must, at a minimum, make adequate disclosure of these terms to all
investors, particularly in certain sensitive areas like liquidity, information
sharing and fees.
2. "Most Favored Nation" Provisions - This is not
a reference to an international treaty of some sort... this is a very common side
letter provision which allows an existing investor with an "MFN" clause to tag
along with newer investors (usually investing less money than they did) who
managed to negotiate a better side term than they did. As a simple
example, the MFN clause might work like this: if Investor A invested $200
million in 2008 and signed a side letter with an MFN clause, and then
Investor B invested $100m in 2011 and got better fee terms than Investor A has,
Investor A would get the benefit of those better Investor B fee
terms. Once thought to make perfect sense and to be somewhat innocuous,
the MFN provisions can tend to pile up on managers. When faced with a situation
where the manager thought just one investor would be invoking their side letter
provision, all of a sudden there can be multiple parties invoking the same
3. Housekeeping Issues - Side letters can impose
obligations on a manager, for example, to provide certain information
about the fund to the side letter investor by a certain date each year.
These obligations need to be tracked by the manager to insure that they are
fulfilled. In addition, some side letters appear to actually restate provisions
of the offering documents. However, these restatements need to be carefully
evaluated to determine whether there is in fact any deviation from the original
In conclusion, hedge fund managers and investors alike
both need to think carefully about side letters: careful drafting by both
parties, followed by proper disclosure and housekeeping by the manager are
Read more articles about the hedge fund industry
and related legal issues at Hedge Rows, a blog by Judith Gross
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