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Aligning Interests: Side Pockets, Side Letters, and Central Issues

bestpracticesThree big issues concern the Alignment of Interests Association, a gathering of investors in alternative investment vehicles who want to ensure (as their name suggests) that their interests are properly aligned with the interest of the managers of those vehicles.

The three major areas of concern or threats of misalignment are: economic and liquidity terms; documentation and governance; transparency, valuation & disclosure.

Economic and Liquidity Terms

Accordingly, the AOI has proposed a set of principles, or best practices, that should apply to transactions throughout the industry. As the CIO of the Employees’ Retirement System of Rhode Island, Anne-Marie Funk, put it in a press release, these principles present “an excellent opportunity for investors to initiate thoughtful discussions with their managers” about such issues are what assets are in the ‘side pockets’ and why, or what other investors have concluded somewhat different bargains than their own.

But let’s start with fees. The proposed principles make a strict distinction between the purposes of management fees on the one hand, and the purposes of performance fees on the other. Management fees are not to be set to generate profit, but rather to keep the lights on, that is, to cover reasonable operating expenses. Further, managers “should provide investors with sufficient information regarding” the light bill and other costs “so that investors can assess the appropriateness of the management fees being charged.”

The performance fee, on the other hand, is precisely where one finds the reward for alpha generation. Here, best practices require a minimum time horizon. Thus, performance fees “should not crystallize more frequently than annually.”

Some strategies necessarily have a longer time-horizon than a single year. These should involve “commensurately longer performance crystallization periods of multi-year clawbacks.”

Managers should eat their own cooking, that is, they should have a significant amount invested in the funds they offer to their investors, and they should re-invest some of their performance allocations there.

The principles allow for side pockets for illiquid investments, but hold that the designation should be clear “at the time of purchase.” If an investment is transferred into a side pocket after purchase, it “should be subject to transparent disclosure as to the rationale for such change in status and when liquidity on the investment is expected.”

Documentation and Governance

A fund’s documents should be consistent; they should be updated in a regular fashion to keep abreast of the “changing investment environment and changing dynamics of the industry;” and they should “reflect the fiduciary nature of the relationship between the manager and investors, and should provide for only a reasonable level of protection for managers.”

The roles, rights, responsibilities, etc. of the various parties (directors, general partners, admins, sub-advisors where applicable) should be set forth in these documents “in a clear and consistent manner.”

A majority of the members of a board ought to be independent, and at least one board member “should primarily represent outside investor interests,” the principles say.

Transparency and Valuation

The principles encourage transparency, even at the position level (with some caveats and through a third party risk aggregator). They regard the production of administrator transparency reports and standardized risk reports alike as a way of enhancing comparability across funds.

Managers should have a “clearly defined valuation policy, committee, and process” and investors should be informed of it, and any material changes in any of those.

Under the heading of valuation policy, the way in which Level 2 and Level 3 assets are designated should be defined and disclosed. The level of assets most open to disputatious valuation, that is, the Level 3 assets, should be subject to valuation by third parties at least once a year wherever possible and practical.

The key terms granted through side letters or new classes of investment/investor should be disclosed to all investors, as should non-routine inquiries or response letters from regulatory bodies, material contingencies or liabilities, the departure of key figures within the management team, and internal “employee-only funds that are not available to outside investors.”


The importance of this document is (as it usually is with such documents) impossible to gauge. To the extent that such lists of principles formulate what the market already inchoately demands, in principle it can serve a crystallizing function, and speed the day when managers across the board, with perhaps always some free-wheeling outsiders, generally provide it.

AOI is an investor-driven organization. It has been around since 2009, and as its website says it has “evolved from closed-door working groups to formalized meetings across multiple locations” with the participation of more than 250 institutional investors, ranging from pensions to family offices.