Perils of Side Letters for Hedge Fund Managers and Investors
Most investors contemplating investing in a hedge fund believe they are presented with a set of fixed terms for their investment. These terms are outlined in the private offering memorandum and appear to apply across the board to all investors. However, careful readers of the offering memo as well as the publicly available registration form (ADV) can ferret out what is often true — that some investors may be subject to more favorable terms. These terms are agreed upon in a “side letter” prior to investment and are usually granted to large or important investors, such as seed investors.
Once thought to be innocuous, if not actually beneficial to a hedge fund, side letters are turning out to be the bain of many managers’ operations. Raising issues ranging from the mundane (housekeeping) to headline-making (SEC regulatory actions), many managers are now thinking twice before granting special terms in a side letter.
Some of the more common issues with side letter usage include:
1. Inadequate disclosure of preferential treatment - This is the area in which regulators may get involved. The most recent example of this is the possible pending SEC case against Philip Falcone’s Harbinger Capital Partners ( http://online.wsj.com/article/SB10001424052970203413304577088440283592970.html) which appears to revolve around the granting of preferential redemption rights to certain investors under the terms of a side letter. Managers granting better treatment to side letter investors must, at a minimum, make adequate disclosure of these terms to all investors, particularly in certain sensitive areas like liquidity, information sharing and fees.
2. “Most Favored Nation” Provisions – This is not a reference to an international treaty of some sort… this is a very common side letter provision which allows an existing investor with an “MFN” clause to tag along with newer investors (usually investing less money than they did) who managed to negotiate a better side term than they did. As a simple example, the MFN clause might work like this: if Investor A invested $200 million in 2008 and signed a side letter with an MFN clause, and then Investor B invested $100m in 2011 and got better fee terms than Investor A has, Investor A would get the benefit of those better Investor B fee terms. Once thought to make perfect sense and to be somewhat innocuous, the MFN provisions can tend to pile up on managers. When faced with a situation where the manager thought just one investor would be invoking their side letter provision, all of a sudden there can be multiple parties invoking the same provision.
3. Housekeeping Issues - Side letters can impose obligations on a manager, for example, to provide certain information about the fund to the side letter investor by a certain date each year. These obligations need to be tracked by the manager to insure that they are fulfilled. In addition, some side letters appear to actually restate provisions of the offering documents. However, these restatements need to be carefully evaluated to determine whether there is in fact any deviation from the original terms.
In conclusion, hedge fund managers and investors alike both need to think carefully about side letters: careful drafting by both parties, followed by proper disclosure and housekeeping by the manager are imperatives.