Fee discounts and most-favoured nation clauses now feature in almost half of all side letters within the hedge fund industry according to a new study by Seward & Kissel, which also found that the number of smaller, newer managers using such agreements has fallen over the last 12 months.
Fee discounts and most-favoured nation clauses now feature in almost half of all side letters within the hedge fund industry according to a new study by Seward & Kissel, which also found that the number of smaller, newer managers using such agreements has fallen over the last 12 months.
The US law firm’s sixth annual study into side letters – specific agreements between investors and hedge funds, which investors often use to secure preferential terms on issues such as fees and liquidity – explored how the content of such agreements is changing, as well as the types and sizes of hedge fund investors and managers using the process.
The research, which was conducted between July 1, 2020 to June 30, 2021, shows that the bulk of side letters (79 per cent) continue to be made with mature hedge fund firms established two or more years prior to the time of the side letter execution, with average AUMs of around USD6.3 billion. In contrast, just a fifth (21 per cent) were with newer managers that founded their business under two years ago, managing assets averaging USD152 million – down from 26 per cent the previous year.
“We believe that the relative underrepresentation by newer managers in the data set is attributable primarily to the continued popularity of founders’ classes in the past several years, which generally decreases the need for special terms in side letters with newer managers,” the report said.
Meanwhile, funds-of-funds dominate on the investor side, accounting for 54 per cent of all side letters agreed, their highest level since the 2017/2018 study and a sharp rise from 42 per cent recorded last year. The second largest side letter investor category was endowments, at 13 per cent, up from 10 per cent of side letters in the previous year’s study.
Government plans (12 per cent), high-net-worth individuals/family offices (12 per cent), corporate pension plans (6 per cent, down from 15 per cent last year), and non-profit institutions (3 per cent) made up the remainder of the side letter investor types.
Delving deeper into the content of side letters, Seward & Kissel found that fee discounts and most-favoured-nation protections continue to be the most popular clauses with investors, each appearing in some 43 per cent of side letters, broadly in line with last year’s findings.
Fee discount clauses were much more common in side letters with new managers (67 per cent) than mature managers (29 per cent), analysis showed. At the same time, more than half (54 per cent) of the fee discount clauses covered both management fees and incentive allocations, while 46 per cent applied only to management fees or incentive allocations.
“The continued prevalence of fee discount clauses is consistent with our observation of sustained interest from large institutional investors such as endowments and government and corporate pension plans, evidencing that these kinds of entities continue to push for fee breaks in their side letter arrangements,” Seward & Kissel added.
Meanwhile, all of the MFN clauses contained a bundling or package concept providing that if a preferential term – such as lower fee – was given to another investor contingent upon a less favorable term – a longer lock-up, for instance – the MFN holder would have to accept the bundle or package of rights, and could not select just the favorable term, the report explained.
Elsewhere, preferred liquidity was included in 35 per cent of side letters, an increase from 27 per cent last year, predominantly among newer manager side letters.
