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Hedge fund side letters survey reveals increase in fee discount clauses

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A new Seward & Kissel study into the use of side letters in the hedge fund industry shows fee discount clauses are now the most common issue raised by investors in such agreements, while the number of smaller hedge fund managers using the practice has increased.

The US law firm’s fifth 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 – shows larger, more established managers remain more likely to use side letters, often seen as a way for managers to securing a large institutional commitment.

But while 74 per cent of side letters were with mature managers, in business for two or more years at the time of execution, the report showed 26 per cent were with newer managers under two years old – an increase from 19 per cent recorded last year.

The average regulatory AUM of the mature managers was around USD5.1 billion – up from USD4.9 billion in last year’s study – while newer managers’ regulatory AUM was USD387 million.

The law firm said the relative underrepresentation among newer managers stems from continued popularity of founders’ classes in recent years, which generally “decreases the need for special terms in side letters with newer managers.”

“This may also suggest investor preference for newer managers that are well-capitalised,” the report said.

On the investor side, funds-of-funds continue to be the most common category of side letter investor, representing 42 per cent of all side letter investors, the report found.

The second largest side letter investor category was government plans, at 18 per cent, and the third largest side letter category was corporate pension plans at 15 per cent. Endowments was fourth, at 10 per cent, while wealthy individuals and family officers were tied with non-profits in fifth place at 7.5 per cent each.

Those stats indicate a “sustained interest in hedge funds” from government plans and corporate pension plans, a trend identified in last year’s study. Elsewhere, 100 per cent of the side letters with government plans and endowments were with mature managers, while half of the newer manager side letters were with funds-of-funds.

Delving deeper into the content of side letters, Seward & Kissel noted fee discount clauses are now the most common issue raised, having been flagged up in almost half (46 per cent) of all side letters surveyed by the report.

Of that number, 53 per cent of fee discount clauses covered both management fees and incentive allocations, while 47 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 government and corporate pension plans, evidencing that these kinds of entities continue to push for fee breaks in their side letter arrangements.”

Most-favoured-nation clauses are less common this year compared to last year’s study – falling slightly from 48 per cent to 44 per cent, and displaced by fee discount clauses as the number one issue in side letters.

“All of the MFN clauses contained a bundling or package concept providing that if a preferential term – eg a lower fee – was given to another investor contingent upon a less favourable term (such as longer lock-up), the MFN holder would have to accept the bundle or package of rights, and could not select just the favourable term,” the study observed.

Elsewhere, preferred liquidity was included in 27 per cent of the side letters, up slightly from the 24 per cent recorded in last year’s study, and more common among newer manager side letters than with established managers.

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