Side letters - Hedge Fund

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Side Letters in Hedge Funds

Definition: Side letters are specialized agreements often entered into between a hedge fund's investor and the fund itself, or sometimes with the fund's investment manager. These agreements contain terms and conditions that are separate from or in addition to the terms outlined in the fund's standard subscription agreement and offering document.

Purpose: Side letters serve various purposes, including offering favorable terms to significant or large investors or accommodating key investors to meet their internal or regulatory restrictions, such as pension funds. These agreements are essentially customized arrangements that cater to specific investor needs.

Popular Side Letter Terms: Common terms found in side letters include:

  1. Waiver or Reduction of Redemption Fees or Lock-Up Periods: Providing more favorable redemption terms to certain investors.
  2. Waiver of Redemption Provisions: Granting exceptions to standard redemption rules.
  3. Shorter Redemption Periods: Allowing certain investors to redeem their investments more quickly.
  4. Modification of Gates and Redemption Restrictions: Customizing gating provisions and other redemption restrictions.
  5. Waiver or Reduction of Management or Incentive Fees: Adjusting the fee structure for specific investors.
  6. Advance Notice of Critical Changes: Notifying investors about significant changes affecting the investment manager or fund.
  7. Limitation of In-Kind Distributions: Restricting the fund's ability to make in-kind distributions to certain investors.
  8. Access to Information: Providing preferential access to information about the fund's investment strategy and financials.
  9. "Most Favored Nation" Provisions: Ensuring that earlier investors receive identical terms to subsequent investors.
  10. Jurisdiction for Arbitration/Choice of Law: Specifying the jurisdiction for dispute resolution and choice of law, especially relevant for pension funds.

Legal Considerations: When considering side letters, certain legal considerations must be taken into account:

  1. Disclosure in Offering Documents: The fund's offering document and articles should disclose the existence and nature of side letters, especially if these letters contain or may contain material terms. This is to ensure transparency for prospective investors.

  2. Definition of "Material Term": The AIMA (Alternative Investment Management Association) Guidance Note on Side Letters provides a definition for "material term." A material term is one that enhances an investor's ability to redeem shares or make determinations regarding redemption in a way that might reasonably put other investors of the same class at a material disadvantage.

  3. Consequences of Non-Disclosure: Failing to disclose side letters in the offering document may lead to the fund acting outside its stated objectives, potentially abusing its powers. This could provide grounds for challenging the transaction.

  4. Flexibility for Additional Classes: The offering document and articles should allow the fund to create additional classes of shares, partnership interests, or units with special rights, if necessary. This is important for accommodating the terms outlined in side letters.

Cayman Islands Law: Under Cayman Islands law, the basic principle is that all investors within the same class must be treated equally concerning their class rights. If the fund intends to grant special terms to a specific investor that amount to class rights, these terms should be detailed in the issuance of a separate class of shares.

In summary, side letters in hedge funds are specialized agreements tailored to accommodate specific investor needs. Proper disclosure and adherence to legal considerations are crucial to maintain transparency and comply with regulatory requirements, ensuring that all investors are treated fairly and equally within the same class.

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