SEC seen eyeing hedge fund 'side letters'
By Jeff Benjamin
August 14, 2006
DETROIT - The $1.2 trillion hedge fund industry's use of so-called side letter agreements has attracted the attention of the Securities and Exchange Commission.
Observers estimate that at least half the more than 8,000 hedge fund managers make separate and sometimes secret deals with certain investors, known as side letter agreements, which outline fees and services.
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These side letter agreements aren't part of a fund's general offering memorandum and can run the gamut from providing increased liquidity to lower management fees to greater portfolio transparency or access to the fund's prime brokers, lawyers and accountants said.
"I would say you see the use of side letters more often than not," said Thomas Westle, partner at Philadelphia law firm Blank Rome LLP. "The problem with side letter agreements is they're obviously giving one investor preference over another yet not disclosing [the special agreement] to everyone else in the fund."
It isn't illegal for one investor to get a benefit over another, meaning that side letters technically are legal. However, the use of side letters is thought to be under some level of review by the SEC because there is concern about disclosure and the potential for conflicts of interests.
An SEC spokesman didn't respond to a request for comment on whether it is investigating the use of side letter agreements, but industry observers say the commission is turning its attention in that direction.
"The SEC staff has indicated side letters will come under scrutiny," said Mitchell Nichter, a San Francisco-based partner at the Los Angeles law firm Paul Hastings Janofsky & Walker LLP.
The focus on side letters, which aren't new to the hedge fund industry, emerged as a byproduct of the SEC's now-abandoned effort to require hedge fund managers to register as investment advisers.
The short-lived rule, which took effect in February, was overturned in June by the U.S. Court of Appeals for the District of Columbia Circuit.
The SEC said last week that it won't appeal the ruling. That move essentially means side letters offered by non-registered hedge fund managers now are beyond the commission's scope.
However, according to some industry observers, the genie already may be out of the bottle, and market pressures could take over in revising the use of side letter agreements.
"It still is an issue, because a lot of hedge funds have not yet withdrawn their registration [with the SEC]," said John Van, chief financial officer at Greenwich-Van LLC in Nashville, Tenn. "You've got to make sure you're not giving too much preferential treatment to one investor over another."
The types of side letter agreements most likely to draw the SEC's attention will involve increased liquidity and portfolio transparency, said Mr. Nichter, adding that "[the SEC's] concerns relate to potential conflicts of interest."
Side letters are most prevalent at smaller hedge funds that are willing to make deals to attract assets, according to James R. Hedges IV, president of LJH Global Investments LLC in Naples, Fla.
"Hedge funds under $1 billion are where you'll see the majority of side letters," he said.
Mr. Hedges added that large institutional investors are the biggest proponents of side letter agreements, because they often require "most-favored nation status," which is the equivalent of the best terms offered any other investor.
Although he described side letters as being "just a part of the industry," Mr. Hedges added that they also create situations that could lead to class actions by those investors left out of the preferential agreements.
As the side letter issue becomes more of an open secret, much of the industry is responding by either avoiding such agreements altogether or fully disclosing their existence, according to industry observers.
"I don't think side letters as concepts in isolation are necessarily good or bad, but the devil is in the details, and the final word will depend on what the agreement says," Mr. Nichter said. "Our experience and advice to [hedge fund manager] clients has been to disclose to all investors the existence of any side letters."
"Aggressive investors are always asking for some kind of special member status," said Larry Eiben, chief operating officer of TFS Capital LLC, a Richmond, Va.-based asset management firm with $60 million under management, including $23 million in two hedge funds.
"The operating agreement of our hedge funds and most hedge funds permit you to offer side letters, and we feel it's not that dissimilar to having an institutional share class in the mutual funds world," he added.
Mr. Eiben said TFS has yet to offer a side letter deal, though that has cost the firm some investors.
The case in favor of side letters typically includes justifying the deal to attract assets that in turn create economies of scale that benefit all investors in a fund.
But the idea of any such preferential treatment doesn't sit well with some hedge fund managers.
"I think it would be a good idea for the SEC to require a disclosure policy on side letters," said Phillip Goldstein, a Pleasantville, N.Y.-based hedge fund manager operating as Opportunity Partners LP, who was the victorious defendant in the lawsuit that led to the reversal of the manager registration rule.
"I don't like side letters, because I don't see how they don't cause a conflict of interest," he said. "If you invest in my fund, you should have a feeling that we're all in this together."
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