Seward & Kissel Side Letter Study Shows Allocations Made to Both Mature and Newer Managers Amid Pandemic

Findings Also Point to Reinvigorated Strength of Funds of Funds

As the COVID-19 pandemic continued to sow uncertainty and volatility in the financial markets over the last year, participants in the hedge fund industry took refuge in familiar deal terms and experienced managers, but also hedged their bets and allocated to newer managers, according to a study by the law firm Seward & Kissel LLP that examines the industry’s use of side letters.

The Seward & Kissel 2020/2021 Hedge Fund Side Letter Study, released today, revealed strong side letter activity in the midst of the pandemic, with investors continuing to allocate funds to mature managers, whose average regulatory assets under management in the study increased from $5.1 billion last year to $6.3 billion this year—while still engaging with newer managers (those with less than two years of experience), as it appears investors have become comfortable with the “new” fundraising environment and leveraged virtual manager and diligence meetings. The study also indicates that in a return to past form, funds of funds once again became the most common type of side letter investor, reversing a downward trend of recent years. Additionally, the consistently popular fee discount clauses continued to be a common term used in side letters, tied this year with most-favored-nation clauses.

The study is Seward & Kissel’s sixth annual analysis of hedge fund side letters—special agreements between hedge funds and their investors—but the first in which the coronavirus pandemic was active through the whole study period (July 2020 to June 2021). For the first time, the study examined capacity rights, finding that they appeared in 17% of side letters. Other notable findings include:

• Accounting for 54% of all side letters, funds of funds reached their highest level since 2017/2018. Other investor types, in descending order of prevalence, were endowments, government plans, high-net-worth individuals/family offices, corporate pension plans, and non-profit institutions.
• Most-favored-nation clauses retained their popularity, appearing in 43% of all side letters, virtually identical to their 44% total in 2019/2020.
• Fee discount clauses also appeared in 43% of all side letters and remained consistent in popularity over the previous two studies, following a sharp rise from 24% in the 2017/2018 study. Fee discount clauses were much more common in side letters with new managers (67%) than mature managers (29%).
• Mature managers executed 79% of side letters analyzed. The average RAUM of newer managers was about $152 million.

“Every industry has faced challenges during the pandemic, and alternative investments are no exception,” said Kevin Neubauer, a partner in Seward & Kissel’s Investment Management Group and the study’s lead author. “But as our sixth annual Side Letter Study reveals, the hedge fund industry has retained a certain level of vibrancy, with strategic choices by managers and their investor base seeming to demonstrate confidence in smaller, newer managers and their ability to be nimble in their investments as well as, unsurprisingly, favoring familiarity and experience with a continued strong interest in larger established managers.”

The Seward & Kissel Side Letter Study follows on the heels of the firm’s first-ever SMA Snapshot Report, which was released in November and contains a detailed analysis of SMAs, their investors, investment strategies, and key terms.

About Seward & Kissel LLP

Seward & Kissel LLP, founded in 1890, is a leading U.S. law firm with an international reputation for excellence. The firm is particularly well known for its hedge fund and investment management work, having established the first hedge fund ever, A.W. Jones, in 1949, and having earned numerous best in class awards over the years.

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