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Seward & Kissel side letter study highlights continued challenges for funds of funds

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A new study by the law firm Seward & Kissel of the hedge fund industry’s use of side letters – special agreements between hedge funds and their investors – shows a marked decrease in the share of side letters issued to funds of funds.

The study also revealed that most-favoured-nation clauses continue to be the most commonly used term in side letters.
The Seward & Kissel 2018/19 Hedge Fund Side Letter Study, indicates that funds of funds received just 37 per cent of all side letters. That figure has dipped substantially from last year’s study, in which they accounted for half of side letters, and the 2016/17 study, 56 per cent. Funds of funds have been replaced in part by government pension plans, which received 19 per cent of side letters this year, up from 7 per cent. With regard to the terms used in side letters, this year’s study tells a tale of continuity rather than change. Last year, most-favoured-nation clauses overtook fee discounts to become the most popular term. That result held again, with 48 per cent of all side letters insisting that the investor receives the best terms that the fund has to offer. 
The study also suggests that a sharp decline in fee discount clauses observed in last year’s Side Letter Study may have been an aberration. Specific findings on this and other issues include:
• The percentage of side letters including fee discount clauses leapt from just 24 per cent last year to 44 per cent this year. That result equals the finding from two years ago, indicating that fee pressure may be back in earnest.  
• While most-favoured-nation clauses were the most popular, they fell seven points from last year, when they appeared in 55 per cent of side letters. The study revealed, however, that newer hedge fund managers (those whose funds have been operating for two years or less) are demanding MFN protection now more than ever. MFN clauses appeared in 90 per cent of side letters with newer managers, up sharply from 67 per cent last year.
• Government retirement plans were considerably better represented in hedge fund side letters this year as compared to last, perhaps reflecting a hunt for large returns to satisfy pension obligations. Their 19 per cent share, however, still does not equal the 27 per cent share they received three years ago.
• Corporate pension plans received 14 per cent of side letters, up from less than 5 per cent last year.
“Our fourth Side Letter Study has again unearthed valuable insights into the continued evolution of hedge funds and their investors,” says Kevin Neubauer (pictured), a senior associate at Seward & Kissel and lead author of the study. “The Seward & Kissel 2018/19 Hedge Fund Side Letter Study demonstrates strategic choices being made by hedge fund managers and their investor base alike.”

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