Hedge funds are organizations that pool and invest client money using aggressive techniques and complex financial instruments. Clients must sign a partnership agreement with a hedge fund before they can invest. A partnership agreement specifies all the rules controlling contributions, withdrawals, profit calculation, fees and other important matters. A side letter is an additional agreement between a hedge fund and a particular client providing special terms beyond those in the partnership agreement. Side letters provide some benefits to its signatories but also create potential issues.
Benefits of Side Letters
A client benefits from a side letter because it confers special valuable rights. For example, a side letter may specify that the investor will be able to withdraw funds without the advanced notice or limits imposed on other clients. Another common feature is to give clients access to certain valuable confidential information withheld from other clients, such as knowledge of an impending takeover offer. Hedge funds benefit from side letters because they might induce wavering potential investors to become clients.
In June 2012, the Securities and Exchange Commission indicted hedge fund manager Philip Falcone on fraud charges. One of the counts alleges that Falcone entered into a side agreement with an unnamed large investor to withdraw $169 million while other clients were forbidden from withdrawing funds. The charge is that Falcone should have disclosed the terms of this side letter to all investors, as its terms materially disadvantaged the other clients of the fund. Hedge fund attorney Judith Gross of JG Advisory Services advises hedge funds to disclose all side letter provisions, especially those involving withdrawal rights, information sharing and fees.
In the lingo of hedge funds, “most favored nation” provisions are side-letter agreements that confer retroactive rights on certain investors. Any side letter that grants MFN status to a client ensures that the client will receive the same rights granted in all future side letters issued to other clients. Investment managers who once thought MFN agreements to be innocuous may grow to resent them, because they extend to all MFN clients benefits granted by any new side letter, such as fee reductions. Side letters can become increasingly costly and hard to manage.
Side letters, especially if widely used, can complicate the administration of a hedge fund. Letters that require certain periodic information disclosures force the fund to maintain the necessary information and ensure it is disseminated properly. As the number of side letters grows, hedge fund managers may find themselves spending significant resources to meet all the special requirements specified in the letters. Even an innocent failure to fulfill a side letter provision might lead to serious repercussions. For example, a failure to disclose a confidential trading opportunity as required by a side letter provision might result in lost profit for the client and perhaps a retaliatory lawsuit.
- The Fundamentals of Hedge Fund Management: How to Successfully Launch and Operate a Hedge Fund; Daniel A. Strachman
- The Hedge Fund Book: A Training Manual for Professionals and Capital-Raising Executives; Richard C. Wilson
- Hedge Funds For Dummies; Ann C. Logue