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Side Pockets

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A Side Pocket is a type of account used by hedge funds to separate illiquid investments from other more liquid assets in a portfolio. Only investors at the time of the creation of the sidepocket will be entitled to a share of the proceeds of the side pocket when it is eventually realized. Future investors will not receive any share of the side pocket.

Investors who receive a share of the side pocket at its creation and subsequently redeem from the fund will still receive a share of the side pocket's value when it gets realized.

Usually only the most illiquid assets receive this type of treatment as holding illiquid assets in a standard hedge fund portfolio can add a great deal of complexity when investors liquidate their position.

What is an illiquid asset?

When an asset is illiquid, it does not mean that the asset has no value. Illiquid assets are difficult to sell because there may not be many buyers interested in purchasing the asset. Common examples of illiquid assets include real estate, antiques and securities that currently have low trading volume, such as those from companies delisted from the major stock exchanges. Investors often refer to stocks with low trading volume as thinly traded stocks.

Once created side pockets can almost be thought of and treated as a sub fund within a fund.

Typically side pocket investments are hard to value and do not even have a comparable security/ assets that can be used to price them against. In these cases it is often left to the fund manager to come up with an internal model to value the investment. As this raises significant conflict of interest issues it is not uncommon for the fund manager to waive any management and/or performance fees in these cases.

How are shareholders affected by the creation of a side pocket?

Existing Shareholders: When a fund manager decides to create a side pocket existing shareholders are allocated shares in the new side pocket account on a pro-rata basis. These shares cannot be redeemed until either the fund manager realizes a portion or all of the side pocket investment.

Redeeming Shareholders: If a shareholder decides to redeem or partially redeem his shareholding from a fund that holds an illiquid asset they may not receive their full entitlement if the valuation of the asset was underestimated. The advantage of using a side pocket is that the proportion of the fund which is represented by the illiquid asset is only redeemed when it is capable of being accurately valued. This avoids prejudicing the redeeming shareholders and assures that the Net Asset Value of the fund is accurate.

New Shareholders: New shareholders will have no entitlement to shares in the side pocket holding the illiquid assets. This protects the new investor from any over estimation of the side pockets valuation and allows them to enter the fund based on the fair value of the remainder of the funds liquid portfolio.

Creating a Side Pocket:

The following issues need to be taken into account when creating a Side Pocket:

  • The existing shareholders will receive a pro-rata share of the new class proportionate to their holding in the fund at the time of creation of the class.
  • The documentation of the fund should be amended to cater for the creation of side pockets. This will include making the necessary updates to the prospectus.
  • The creation of the side pocket represents a change in the terms upon which investors originally invested in the fund and consequently the approval of the shareholders will be required to create the side pocket.
  • The new class alone will benefit from any interest, dividend or other income accruing to the side pocketed investment.
  • Shares in the new side pocket class can only be redeemed when the illiquid assets can be valued accurately.
  • The new class of shares will be valued on each dealing day.

SEC and Side Pockets

Since 2010, the Securities and Exchange Commission (SEC) has launched numerous investigations into side pocket accounts. These investigations have been launched in response to investor complaints regarding their inability to redeem their side pocket hedge fund shares on demand. The SEC investigations include the valuation methods that fund managers use for side pocket accounts, due to a concern that the managers may be overstating their value. The SEC is looking into the general lack of disclosure given to investors regarding asset allocation percentages from the general portfolio into side pockets.

With the liquidity issues suffered by Hedge Funds in recent years it is no longer unusual to see funds create side pockets for the treatment of illiquid assets. Side pockets can however create as many issues as they solve. Here are a few:

  • Some parties feel side pockets are just another way of protecting manager's fees by putting certain investments into a magic box - never to be seen again.
  • Complex issues have arisen surrounding the crystallisation of performance fees and the adjustment of High Water Marks. This just serves to highlight the potential conflict of interests that may emerge over time.
  • It is essential that the framework for how and when side pockets can be created be laid out in order to avoid contentious issues arising from the extent of the manager's discretion to designate investments into a side pocket.
  • Creditors agreements should be put in place where the side-pocketed investment has been leveraged. This is necessary to prevent creditors having recourse to the liquid element of the portfolio.
  • Using side pockets has been viewed as adding a layer of secrecy and susceptible to abuse if the side pocket investments are not included in the fee calculations.

Executed properly, side pockets are a useful tool to help level the playing field for investors in a hedge fund which is experiencing liquidity issues. Creating a side pocket is not a silver bullet for fund liquidity issues and serval operationial and ethical issues must be considered before creating one. The main concern should be the fair treatment of all investors in the fund.

What you've learned in this lesson:

  • definition of a side pocket
  • reasons for creating one
  • how shareholders are affected
  • issues to be considered when creating a side pocket
  • concerns around side pockets

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