Side pockets

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Title: Navigating Hedge Fund Illiquidity: Understanding Side Pockets

In the intricate world of hedge funds, the ability to manage illiquid investments efficiently is crucial for both investors and fund managers. This is where the concept of "side pockets" comes into play. Side pockets are a valuable tool that allows hedge funds to segregate illiquid or hard-to-value assets from their liquid portfolio. In this article, we will explore the intricacies of side pockets, their purposes, common characteristics, and the regulatory landscape surrounding them.

What Are Side Pockets?

Hedge funds are known for their focus on liquid assets that can be regularly valued. This valuation is essential for various purposes, such as determining subscription and redemption prices for investors and calculating management and performance fees. However, certain investments may become illiquid due to factors like delisting, suspension, or litigation, making them challenging to value accurately.

Side pockets provide a solution by isolating these illiquid or hard-to-value assets from the fund's primary liquid investments. This segregation allows investors to continue subscribing to and redeeming shares while preserving the potential value of the side-pocketed assets. Investments that typically find themselves in side pockets include real estate, private equity, distressed securities, bankruptcies, and reorganizations.

Why Are Side Pockets Used?

The use of side pockets becomes necessary when the inclusion of illiquid assets in a hedge fund's general portfolio disrupts valuation, accounting, allocation, and liquidity provisions. Here are a few reasons why side pockets are used:

  1. Accurate Valuation: Illiquid assets in the general portfolio can only be valued at their acquisition cost or the fair value assessed by the investment manager, rather than a quoted market price. This can distort the fund's net asset value.

  2. Fairness Among Investors: If some investors redeem their interests in a fund that includes illiquid assets, the remaining investors may end up with a disproportionately large exposure to these assets.

  3. Performance Fee Calculation: Performance fees are usually not charged on illiquid assets until they are realized. This means that unrealized gains on these investments do not affect the performance fee calculation based on quoted market prices.

Characteristics and Mechanics of Side Pockets

Side pockets typically have the following characteristics and mechanics:

  • Limited Participation: Only investors present at the time a side pocket is created can participate in the profits or losses of the specific investment allocated to the side pocket.

  • Lock-Up Period: Investors in a side-pocketed investment are locked in, and they cannot redeem their shares until the investment becomes liquid or is deemed realized.

  • Management and Performance Fees: Management fees may be accrued and paid when the side pocket investment is realized or deemed realized. Performance fees are usually charged only when the asset is realized, ignoring potential losses in the liquid shares.

Creating Side Pockets

The decision to create a side pocket is typically at the discretion of the investment manager. Once identified as an illiquid investment, a portion of each investor's equity interest is converted into a new class of non-redeemable equity interests, representing the fund's investment in the illiquid asset. Generally, only investors present at the time of side pocket creation can participate in the profits and losses of the investment in the side pocket.

The Planned Approach vs. Synthetic Side Pockets

Many hedge funds incorporate side pocket provisions into their fund documents from the beginning. These provisions specify how special investments will be allocated among shareholders, investment limits, conversion rights, and more.

In cases where side pockets are not explicitly authorized by a fund's documents, a "synthetic side pocket" approach can be employed. This involves creating a subsidiary of the fund to indirectly convey illiquid assets to investors through in-kind redemptions.

Regulatory Considerations

Regulators like the FSA and SEC are increasingly focused on transparency and disclosure regarding side pockets. They are considering guidelines for the use of side pockets and the valuation of assets within them. The discretion of investment managers to establish side pockets is being scrutinized to prevent potential abuses.

In Conclusion

Side pockets are a valuable tool for hedge funds to manage illiquid investments effectively. They provide a fair and transparent way to separate these assets from the liquid portfolio, ensuring that investors are treated equitably. As regulatory oversight increases, it's crucial for hedge funds and their managers to adhere to best practices and ensure proper disclosure when using side pockets. By doing so, they can navigate the challenges of illiquidity while maintaining investor trust and confidence.

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