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Side Letters and Side Pockets: Back Office Time Bombs?

June 26, 2006
By Carol E. Curtis

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.

"Under SEC oversight, side deals could become a legal risk for hedge funds--if they are not disclosed or are used abusively."

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.

In the case of side pockets, an important concern is valuation, says Zebrowski, since they call for special accounting treatment for illiquid investments: "Technology can play a key role by installing a well-organized internal control structure around the valuation process."

However, according to Zebrowski, few technology firms have the requisite intellectual capital to build such enterprisewide compliance automation systems. He says that TurboCompliance works in concert with chief compliance officers, attorneys and accountants to automate internal control structures around the workflow of each business process, including side letters and side pockets.

As the use of these special arrangements continues to grow, more technology suppliers are likely to respond. As Nelson says, "There has been a good deal of innovation among vendors who have seen this opportunity."