Hedge Funds’ Side Letter Usage Remains Constant, as Redemptions Continue

51% of all investors using the individualized agreements are fund-of-funds investors, while $20.75 billion was redeemed from hedge funds in September.

Investor net flows into hedge funds were negative in September, a fourth consecutive month, according to eVestment’s Hedge Fund Asset Flow report.

Investors pulled an estimated $20.75 billion from hedge funds over the course of the month, while overall assets declined to an estimate of $3.423 trillion, slumping $75 billion on the back of redemptions and negative equity performance.

Only hedge funds with the primary strategy of managed futures, saw net inflows during September, with Q3 net outflows finishing well above average, eVestment reported. But despite the large amount of redemptions, the relative outperformance of hedge strategies in comparison to major public equity and credit benchmarks have been a highlight for many funds.

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Only 39% of hedge fund managers surveyed indicated that they had inflows for the month of September, the lowest read in this metric since March 2019.

According to a Hedge Fund Side Letter Study released by Seward & Kissel, the average regulatory assets under management of mature managers (managers in business for two or more years) was approximately $4 billion.

Side letters are stipulations to the management agreement which set out terms that supplement the governing partnership agreement and are typically memorialized in a letter executed by a fund manager and acknowledged by a negotiating limited partner, hence the term ‘side letter.’

The six principal types of side letter investors that were most common within the study were, funds-of-funds investors; endowments; non-profit institutions, government plans (which includes both U.S.-based and non-U.S. sovereign wealth plans), corporate pension plans and family offices/LP stakes operated by high-net-worth individuals.

Fund-of-funds side letter investors made up the greatest portion of the study, with 51% of all side letter investors being fund-of-funds investors.

Other findings included that corporate pension plans and non-profit institutions allocated only to mature managers, both government plans and endowments invested with newer managers (managers with less than two years of operation), and that government plans tended to write the largest checks, investing sums typically in the tens of millions to hundreds of millions range.

The study focused on five principal business terms in side-letter arrangements, including most favored nations protections, aka an MFN clause; fee discounts; preferred liquidity; capacity rights; and transparency and reporting obligations. MFN provisions stipulate a guarantee that the signing investor will not be disadvantaged compared to other investors in subsequent rounds.

MFN provisions appeared in 46% of side letters. Fee discount clauses appeared in 34% of all side letters, preferred liquidity was included in 18% of the side letters, and capacity rights appeared in 15% of the side letters. The least common side letter term was portfolio transparency/reporting obligations, which appeared in just 8% of all side letters.

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