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Side Letters and Side Pockets: Back Office Time Bombs?
June 26, 2006
Are so-called "side pockets" and "side letters" potential back-office time bombs? And if so, can technology help to defuse them?
A side letter is a special arrangement between a fund and an investor, granting preferential terms. For example, an investor may negotiate a reduced fee arrangement or may increase liquidity by eliminating a lock-up period. A side pocket is a portion of a hedge fund with a different liquidity provision--a kind of fund within a fund with its own redemption and contribution rules, amounting essentially to a different class of shares--and is a way for the funds to put money into less liquid investments, such as private companies and real estate, which are more difficult to value than assets that trade frequently (Securities Industry News, May 8).
These side deals have been increasing as
pension funds move more money into hedge funds--and seek special
treatment due to internal or government-imposed policies. Also,
early-stage hedge fund investors often seek preferential terms to
compensate for their risk-taking. Side pockets have become more
popular as hedge funds seek a competitive edge by investing in
illiquid securities. "Over the last decade, fund managers simply
swept these [side deal] issues under the carpet," says Walter
Zebrowski, CEO of TurboCompliance, a New York-based hedge fund
services provider. But now, Securities and Exchange Commission
oversight of hedge funds can transform side deals into time bombs.
"Under SEC oversight, side deals could become a legal risk for
hedge funds--if they are not disclosed or are used abusively," he
says.
"So long as it is disclosed [in the offering memorandum], it is up to the investor to decide if they still want to invest with the hedge fund manager," says Stephanie Pries, VP and legal counsel with the Washington, D.C.-based Managed Funds Association.
"Under SEC oversight, side deals could become a legal risk for hedge funds--if they are not disclosed or are used abusively."
An example of abuse would be a hedge fund partner's side letter with a brokerage outside the fund to route commission dollars directly to the partner. Or a hedge fund could use a side pocket agreement to hide bad investments, and therefore the true nature of its performance. In fact, side letters have come up in enforcement cases, says Lindi Beaudreault, a partner in the Washington, D.C. law firm LeClair Ryan and a former senior counsel in the SEC's enforcement division. The legal risk to the adviser comes from giving preferential treatment to an investor without disclosing it, which constitutes fraud, she says.
Managing side deals adds layers onto an already complex administrative process and necessitates development of special technology. Matt Nelson, senior analyst at Needham, Mass. research firm TowerGroup, says that managing side letters requires a partnership accounting system such as Advent Partner from Advent Software of San Francisco. "Advent's adoption by large global hedge fund administrators is a statement that they have built out many of the capabilities needed to support the business," Nelson says. Competing products include Front Arena from SunGard Data Services of Wayne, Pa., and AdvisorWare from SS&C Technologies of Windsor, Conn.
