In the world of hedge funds, the rights,
opportunities, fees and, most importantly, information available to one investor
may look completely different than those
available to another in the same fund. The
documents that outline these special privileges are called hedge fund side letters, and
not being aware of the ones associated
with your investments could hurt you.
“Hedge fund side letters are agreements
that provide certain investors with more
favorable terms than those offered in the
fund’s standard offering documents,” says
Rebecca Edwards, a corporate attorney in
the corporate practice group with the
Chicago law firm of Levenfeld Pearlstein
LLC. “For example, side letters may provide
certain investors with lower management
fees, more frequent opportunities to withdraw their investments from the fund, and
enhanced or early information regarding the
management or investments of the fund.”
Smart Business discussed with Edwards
the impact of hedge fund side letters on
investors, current regulations in the industry and how to best protect your interests.
How can side letters affect hedge fund
investors?
Regulators are concerned that side letters can enable certain investors that are
better informed to exit the fund ahead of
others when the fund is not performing
well. Additionally, side letters may provide
certain investors with better investment
returns if the management fees paid by
such investors are lower.
What type of disclosures do managers usually provide investors?
Often hedge fund offering documents
simply disclose that the fund has the ability to enter into side letters with investors.
If possible, investors should request
copies from the fund of any specific side
letters. This helps interested parties to
evaluate their potential risk if other members of the fund choose to exercise their
special privileges.
Regulators have taken the position that
managers should disclose side letters to
investors or create a separate class of interests if such side letters promote unequal
treatment of investors. This separate class
of interests could justify why such
investors are being treated differently.
However, hedge fund managers may not
follow these guidelines so investors still
need to investigate the existence of side
letters to ensure they have a clear understanding of their investment situation.
What SEC regulations pertain to side letters?
There are no SEC regulations that specifically pertain to side letters. In fact,
because hedge fund managers are not usually required to register with the SEC,
hedge fund investors generally do not
receive all of the federal and state law protections that commonly apply to most registered investments.
Attempts by the SEC to require hedge
fund managers to register with the
Investment Advisers Act by the SEC have
been thwarted. In June 2006, the court in
Goldstein v. SEC overturned the SEC’s
manager registration rule and sent it back
to the SEC for review. This means hedge
fund investors need to take more personal
responsibility for confirming that investment decisions are made in their best
interest.
How can investors become more aware of
relevant conflicts of interests?
Conflicts of interest are common in the
management of hedge funds. Investors
should make sure that the offering documents disclose conflicts of interest and
look for funds offering documents that disclose the funds’ ability to enter into side letters. At the outset of the process, investors
should have all of these disclosures evaluated by an experienced attorney. Investors
should also research the scope of the manager’s activities, including what other funds
the individual manages and what outside
business activities fall under this person’s
supervision.
Are there any new legal developments with
side letters?
Although there are no new regulatory
developments in the United States, the
Alternative Investment Management Association (AIMA), a United Kingdom trade
association, issued guidance regarding side
letter disclosure standards in 2006. This
guidance assists firms in complying with
U.K. Financial Services Authority (FSA)
requirements.
The FSA stated that it expects hedge fund
managers to ensure that all investors
understand that a side letter has been
granted and that conflicts may arise in
Feedback Statement FS06/2. In response,
AIMA further provided that investment
advisers should disclose the existence of
side letters that contain ‘material terms’
and the nature of any such terms. A ‘material term,’ as defined by AIMA, includes any
term that is reasonably expected to put
other shareholders at a material disadvantage. Examples include grants of preferential exit rights, giving certain investors portfolio transparency rights, ‘key man’ provisions, and percentage of investor holdings
where grants go to investors owning more
than 10 percent of the fund.
REBECCA EDWARDS is a corporate attorney in the corporate practice group with the Chicago law firm of Levenfeld Pearlstein LLC.
Reach her at (312) 476-7588 or [email protected].