Side pockets are special accounts used by some hedge funds and other alternative asset managers to segregate risky or illiquid assets from the main fund. They gained popularity during the 2008 financial crisis as a way to prevent investor redemptions from impacting holdings that could not be easily sold. While side pockets can provide flexibility, they also have drawbacks for investors. This article examines the key benefits and risks of side pocket investments.
What are side pockets and how do they work?
A side pocket is a separate account linked to a hedge fund or private equity fund that is used to hold certain investments, usually those that are hard to value or trade. The assets in a side pocket do not impact the net asset value (NAV) calculations of the main fund. Investors cannot redeem the side pocket assets until the manager decides to liquidate them and distribute the proceeds. Managers may use side pockets to isolate holdings like private companies, distressed debt, illiquid securities, or investments caught up in litigation. The goal is to prevent mass investor redemptions from forcing the sale of these assets at unfavorable prices. Overall, side pockets provide flexibility for managers to maintain investments through periods of market turmoil.
The benefits of side pockets
There are several potential benefits to using side pockets in hedge funds: – Prevents fire sales of illiquid assets – Fund managers don’t have to sell at distressed prices – Managers can take a long-term view for turnarounds – Main fund NAV is insulated from hard-to-value holdings – Solves mismatch between liquidity terms and underlying assets – Provides flexibility for funds holding some private investments
The drawbacks of side pocket investments
However, side pockets also come with risks for investors: – Reduced liquidity – Investors cannot redeem side pocket assets until liquidated – Valuations can be uncertain – Side pockets may overvalue distressed assets – Lack of transparency – Details may be limited for side pocket holdings – Potential for conflicts of interest – Managers may use side pockets for self-interest – Concentrates illiquid risks – Risks not diversified like the main fund Overall, investors should weigh the pros and cons of reduced liquidity, valuation uncertainties, transparency, and potential conflicts of interest with side pocket arrangements.
Regulations for side pockets
Side pockets are loosely regulated in the hedge fund industry. In the U.S., the main requirements are: – Disclosure in offering documents – Managers must disclose the possibility of side pockets – Advance notice to investors – Investors must approve the side pocket transfer – External valuations – Holdings should be valued independently and regularly – Timely distributions – Proceeds must be distributed promptly when liquidated The lack of specific limitations on side pockets allows substantial flexibility for fund managers but also places a great deal of trust in their integrity and aligned interests.
Critical considerations for side pocket investments
When evaluating potential investments involving side pockets, investors should carefully assess: – The fund’s past use of side pockets – Look for patterns of overuse or conflicts of interest – The assets destined for side pockets – Higher risks for distressed or opaque holdings – The valuation process and providers – Require independence and expertise – Fees on side pocket assets – May be higher than the main fund – Liquidity prospects after transfer – Consider economic cycles and turnover – Manager communications on realizations – Look for timely notifications and distributions Given the pros and cons, side pocket investments require extensive due diligence and monitoring. But they may play a niche role for suitable investors.
Side pockets allow hedge fund managers to isolate hard-to-value or illiquid assets with both benefits and drawbacks for investors. Careful evaluation of their use and oversight through economic cycles is key.