Side Pockets Investments

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The concept of side pockets in investment funds is a mechanism used to segregate illiquid or hard-to-value securities from the fund's normal trading portfolio. Here are the key points and considerations related to side pockets:

1. Purpose of Side Pockets:

  • Illiquid or Hard-to-Value Securities: Side pockets are created when certain securities held by a fund are illiquid or challenging to value. This separation helps protect the fund from the effects of investor withdrawals related to these securities.
  • Valuation Issue Mitigation: Side pockets can be used to eliminate valuation issues, especially when a fund has periodic openings where a solid net asset value is required.

2. Participation:

  • Participation in side pockets is typically based on either the investor's pro rata share of the entire fund or proportional to the non-side pocketed capital at the time of acquisition.
  • Fund documents should specify participation limits and address the effects of additions and withdrawals near the time of side pocket creation to ensure fairness.

3. Expenses and Fees:

  • Allocation of expenses and fees related to side pockets is crucial. The allocation methods can vary, and it's important to maintain transparency and fairness.
  • Fund-wide expenses, management fees, and holdbacks should be carefully considered and substantiated, especially when they are charged based on side pocket capital values.

4. Incentive Allocations:

  • Incentive allocations can be based on specific events, such as a sale or becoming liquid, or they may be vague in fund documents.
  • The approach taken for incentive allocations should be in accordance with the fund's documents, approved by the fund auditor and attorney.

5. Disclosures:

  • When a fund creates a side pocket, it should provide clear disclosures to investors, explaining the reasons for creating the side pocket, its duration, and other relevant details.
  • Year-end audits should include specific information about the side pocket, such as limitations on participation and valuation.

6. Offshore Structures:

  • Side pockets are less common in offshore funds due to complexities in share accounting and higher concerns about liquidity among non-US investors.
  • In offshore funds, side pockets are often established in special classes, with capital obtained through share redemptions from existing normal series.

7. Reporting Results:

  • Side pockets are typically not included in fund-level performance reports because they are not shared by all investors.
  • The percentage return on normal commingled capital is considered more accurate, and including side pocket valuations can diminish the accuracy of performance reporting.
  • Side pocket pay-offs or write-downs are event-driven, and their inclusion in monthly returns can be misleading.

8. Fairness and Transparency:

  • The ultimate goal of using side pockets should be fairness and transparency to both existing and new investors.
  • Decisions related to side pockets should consider the complexity they add and the materiality of the assets involved, with consultation with fund counsel, auditors, and administrators advised.

In summary, side pockets are a mechanism to address illiquidity or valuation challenges in investment funds, but their use involves careful consideration of participation, expenses, fees, incentives, disclosures, and reporting to ensure fairness and transparency to investors. Consulting with legal and financial experts is recommended when implementing side pockets in a fund.

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