Side letter

Side letters are special agreements that allow hedge fund managers to offer customized terms to specific investors. These agreements work alongside the main fund documents that apply to all other investors. Think of them as individual contract modifications that address two main types of investor needs.

First, side letters can address unique requirements that certain investors face due to their own regulations, tax situations, or operational constraints. For example, a pension fund might need specific reporting formats to comply with government oversight rules.

Second, side letters can provide preferential rights that give certain investors better treatment than others in the fund. These advantages might include lower fees, better redemption terms, or enhanced information access.

Side letters exist because large institutional investors—like pension funds, sovereign wealth fundsState-owned investment funds that manage a country's reserves for long-term investment purposes., or major endowments—often have significant negotiating power. They bring substantial capital to hedge funds, sometimes hundreds of millions of dollars. This gives them leverage to request special terms that smaller investors cannot obtain.

Fund managers face a delicate balancing act when using side letters. They want to attract valuable capital from large institutions, but they also have legal obligations to treat all investors fairly and transparently.

Large institutional investors typically negotiate for several types of enhanced rights through side letter agreements. Understanding these common provisions helps explain why side letters are so prevalent in the hedge fund industry.

Fee-related provisions often represent the most valuable negotiated terms. These might include reduced management fees Management fee Management fee refers to a recurring fee, typically calculated as a percentage of assets under management, that hedge funds charge investors to cover operational and administrative expenses regardless of fund performance. , lower performance fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. , modified [hurdle rates](/compliance/hurdle-rate, or alternative methods for calculating fees. For instance, an investor contributing $500 million might negotiate a management fee of 1.5% instead of the standard 2%.

Liquidity enhancements address one of hedge funds' most significant limitations—restricted access to invested capital. These provisions might include more frequent redemption opportunities, shorter redemption notice periods, reduced or completely waived lock-up periods Lock-up period A lock-up period is a specified timeframe during which investors in a hedge fund are prohibited from redeeming their investment, designed to provide the manager with stable capital to execute the investment strategy. , and priority treatment when the fund processes redemption requests.

Information and transparency rights give investors access to more detailed information than standard investors receive. This might include enhanced portfolio disclosure, more detailed performance reporting, operational insights beyond regular investor communications, and sometimes complete portfolio transparencyThe level of detail provided to investors regarding fund holdings and investment positions. showing every position the fund holds.

Governance provisions allow investors to influence fund operations in specific ways. These might include consultation rights before key personnel changes, the ability to request certain investment restrictions, and participation in advisory committeesGroups of investors or industry experts that provide input and guidance on fund strategy and operations. that provide input on fund strategy.

Most favored nation clauses ensure that investors automatically receive any superior terms that the fund manager later grants to other investors. These provisions require careful drafting to address exactly which terms are covered, when they apply, and how they are implemented.

Fund managers must navigate significant legal obligations when implementing side letter arrangements. The most important principle is the duty of fairnessThe obligation to treat all investors equitably and ensure that preferential arrangements do not materially harm other investors.—preferential terms for some investors cannot materially harm other investors or compromise the fund's overall investment strategy.

This duty extends beyond simply telling investors about side letters. Fund managers must substantively evaluate whether enhanced rights for some investors create corresponding disadvantages for others. For example, if one investor gets priority redemption rights, this could potentially delay redemptions for other investors during market stress.

The regulatory landscape for side letters changed significantly in June 2024 when the Fifth Circuit Court of AppealsFederal appellate court that reviews decisions from district courts in Texas, Louisiana, and Mississippi. vacated the SEC's Private Fund Adviser RulesSEC regulations that would have imposed additional disclosure and operational requirements on private fund advisers before being overturned by the Fifth Circuit Court of Appeals.. These rules would have imposed strict limitations on side letter arrangements, but their elimination means fund managers now operate under traditional fiduciary principlesFundamental legal concepts requiring advisers to act in their clients' best interests with loyalty and care. rather than specific prescriptive restrictions.

This gives fund managers more flexibility in structuring side letter arrangements, but they remain subject to anti-fraud provisionsRegulatory requirements that prohibit deceptive or misleading practices in financial communications and transactions. and general fiduciary dutiesLegal obligation to act in the best interests of another party, requiring utmost good faith and loyalty. under the Investment Advisers Act of 1940 Investment Advisers Act of 1940 The Investment Advisers Act of 1940 is the primary U.S. legislation regulating investment advisers, including hedge fund managers, establishing registration requirements, fiduciary duties, disclosure obligations, and compliance standards for advisers meeting certain thresholds. . The key requirement is that all arrangements must be consistent with the fund manager's fundamental obligation to act in the best interests of the fund and its investors.

Managing side letters effectively requires comprehensive disclosure strategies that balance transparency obligations with confidentiality concerns. Fund managers typically address this challenge through their offering documents—the legal materials provided to all potential investors.

These documents generally disclose the fund manager's authority to enter side letter agreements and provide broad descriptions of the types of preferential arrangements that might be granted. However, they typically do not reveal the specific terms negotiated with individual investors, as these arrangements often involve confidential commercial informationProprietary business information that is not publicly available and requires protection from unauthorized disclosure..

The scope and timing of specific disclosures depend on the nature of the preferential terms and their potential impact on other investors. Enhanced liquidity rights, for example, may affect how the fund manages its overall liquidity and could impact other investors' redemption experiences. In such cases, more detailed disclosure may be appropriate.

Fund managers must also consider ongoing disclosure obligations. If side letter arrangements change materially or if new types of preferential terms are introduced, investors may need to be notified to maintain transparency and fairness.

Information-focused side letter provisions present particular challenges because they can create informational imbalancesSituations where some investors have access to material information that gives them advantages over other investors in making investment decisions. among investors. When some investors receive enhanced reporting or portfolio transparency, they may be able to make more informed investment and redemption decisions than investors who only receive standard communications.

This informational advantage could potentially disadvantage other investors, particularly if the enhanced information enables some investors to redeem their capital before market downturns that other investors cannot anticipate. Fund managers must carefully structure these arrangements to minimize unfair advantages.

Confidentiality obligations add another layer of complexity. Recipients of enhanced information typically agree to strict confidentiality requirements to prevent the misuse of material non-public information. However, these obligations can be complicated when dealing with government entities subject to freedom of information lawsGovernment transparency statutes that provide public access to documents and records held by government agencies., which may require public disclosure of certain information they receive.

In these cases, fund managers may need to negotiate specific disclosure limitations or information withholding provisions to protect sensitive fund information while still providing the enhanced reporting that government investors require.

Fee-related side letter provisions require careful analysis of their impact on fund economics and other investors. While fee reductions represent private commercial arrangements between the fund manager and specific investors, best practices typically include disclosing the fund manager's general discretionary authority to modify fee arrangements.

Seed investors—those who provide initial capital to help launch a fund—often negotiate enhanced economic terms in recognition of their early commitment and the risks they take by investing in an unproven fund. These arrangements might include permanently reduced fees, enhanced liquidity rights, or profit-sharing arrangements.

Other strategic partners may also receive enhanced economic terms. For example, an investor who provides operational support, introduces other investors, or offers valuable expertise might receive preferential fee treatment in recognition of these contributions beyond their capital investment.

These arrangements must be structured carefully to avoid creating inappropriate subsidizationThe practice where some investors effectively bear higher costs to support preferential arrangements given to other investors. where other investors effectively pay higher costs to support the preferential treatment given to strategic investors. The goal is to ensure that enhanced terms reflect genuine value provided rather than simply the investor's negotiating power.

Running a successful side letter program requires robust operational infrastructure to track diverse arrangements, ensure compliance with varying obligations, and maintain appropriate confidentiality. This operational complexity increases significantly as the number and variety of side letter arrangements grows.

Fund managers should maintain comprehensive records of all side letter provisions, including detailed tracking systems that monitor different requirements for different investors. For example, one investor might require monthly reporting while another needs quarterly reports in a specific format, and a third might have enhanced redemption rights that require special processing.

Clear escalation proceduresPredetermined processes for handling conflicts or complex situations that require higher-level decision-making or resolution. are essential for handling conflicts between competing obligations. For instance, if two investors with different side letter arrangements both submit redemption requests that cannot both be fully satisfied, the fund manager needs predetermined procedures for fairly resolving such conflicts.

Legal counsel review remains essential throughout this process. The complexity of balancing fiduciary duties, regulatory requirements, and commercial objectives while preserving operational flexibility makes professional legal guidance crucial for effective side letter management.

Regular review and updating of side letter programs also helps ensure they continue to serve both the fund's capital-raising objectives and its fiduciary obligations as market conditions and investor needs evolve.