A new study by the law firm Seward & Kissel into the hedge fund industry’s use of side letters –special agreements between hedge funds and their investors – shows a major shift in the hedge fund landscape.
In The Seward & Kissel 2017/18 Hedge Fund Side Letter Study, the percentage of side letters containing fee discounts significantly decreased, while those with preferred liquidity increased dramatically. In addition, overall average regulatory assets under management grew, as did the number of newer managers registered with the SEC (an increase of nearly 33 per cent, compared to last year). These developments seem to point to efforts by managers to raise more capital in order to pay increasingly higher operational costs to serve investor and regulatory demands.
The study finds that as fees may be reaching a floor level, fee discounts were included in just 24 per cent of side letters, down from 49 per cent last year, when they were the most common term used in side letters.
Fee discounts meanwhile, have been surpassed by most favoured nations clauses (appearing in 55 per cent of side letters) and preferred liquidity clauses (27 per cent), the use of which has skyrocketed over the last two years. In 2015-16, preferred liquidity clauses appeared in fewer than 7 per cent of side letters.
Continuing a two-year-long trend, government plans also continued to shrink as an investor category. They accounted for just 7 per cent of all side letter investors, down from more than 27 per cent two years ago.
As government plans have withdrawn, non-profit institutions have emerged. Non-profits, including large medical or religious institutions, represented the second-largest investor category (after funds-of-funds), accounting for 14.2 per cent of side letters (up from 4 per cent in the prior year’s Study).
“Our third Side Letter Study has again unearthed valuable insights into the continued evolution of hedge funds and their investors,” says Steve Nadel (pictured), partner at Seward & Kissel and lead author of the Study. “The Seward & Kissel 2017/18 Hedge Fund Side Letter Study demonstrates that managers are listening to their investors and are making strategic choices as the industry continues to change.”
