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Funds-of-Funds Most Likely to Receive Preferential Hedge Fund Terms

Law firm Seward & Kissel’s study of side letter agreements found more than half of these arrangements were with funds-of-funds.

As hedge fund investors continue to demand lower fees, some allocators — funds of funds in particular — are securing discounts through so-called side letters.

Side letters, or side agreements promising certain investors preferential terms, had fallen out of fashion after 2006, when both the U.S. Securities and Exchange Commission and the Financial Services Authority, as the U.K.’s market regulator was then known, began looking into possible conflicts of interest inherent in the practice.

But Seward & Kissel, a U.S. law firm with corporate finance and investment management practices, points to a possible resurgence in side letter arrangements. The firm’s second-annual study examined the side letter use of its hedge fund clients.

Seward & Kissel said the trends among its client base show a growing embrace of side letters among emerging managers. Hedge fund managers less than two years old made up 20 percent of side-letter users, up from 13 percent last year.

However, the law firm reported that the average dollar amount invested with new managers through side letters — $53.65 million — was “substantially” less than the average $82.62 million committed via side letters to more experienced managers. The experienced managers surveyed controlled an average of $4.37 billion in regulatory assets under management (RAUM), according to their latest SEC filings. The RAUM figure represets a firm’s gross assets, including leverage.

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Additionally, the survey found that the majority of side-letter agreements were made with funds of funds, which made up 56 percent of side letter investors — up from just 30.5 percent last year.

Wealthy individuals and family offices accounted for 17 percent of side letter arrangements, while public pensions made up 14 percent.

Almost half of the side letters in the study included fee discounts, while another 47 percent had some form of “most favored nations” protection — a clause promising the client is receiving the best terms offered by the hedge fund.

Roughly a quarter of side letters featured transparency and reporting requirements, while 11.4 percent included preferred liquidity terms.

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