A side pocket is simply an account that is set up by a hedge fund, separating specific assets or investments from the fund’s general portfolio. While it is an entry on the hedge fund’s books, it is tracked separately from the hedge fund’s investments.
Side pockets are often used by Cayman Islands hedge funds to hold securities such as real estate and private equity investments that have low liquidity. An example would be a large investment held by the hedge fund becoming illiquid and hard to sell because there may not be many interested buyers in the asset. Examples of hard-to-value illiquid assets could include antiques, real estate, private equity investments and securities with low trading volume, such as those from delisted companies.
Only the most illiquid assets are generally treated like this, because holding illiquid assets in a standard hedge fund portfolio often results in a great deal of complexity when an investor wants to liquidate their position.
Cayman fund directors will usually place a limit on the amount of assets which can be placed in the side pocket investments, which is usually calculated as a percentage of the hedge fund’s assets, based on the purchase price of the investment in the side pocket.
The primary purpose of a side pocket investment is to ensure that the manager is not underpaid or overpaid from a valuation before a fund’s investment is sold. For instance, if a manager held a piece of property in a non-side pocket account it would be difficult to find a valuation for the overall portfolio because the property is difficult to value and may be a substantial part of the fund’s portfolio.
As side pocket investments are by their very nature hard to value, it is often left up to the fund manager to come up with an internal model to value the investment. Because fund managers are paid a performance fee on both unrealized and realized investments, significant conflict of interest issues come into play and there could be an incentive to overvalue the illiquid asset.
Because of this potential conflict of interest it is not uncommon for a fund manager to waive any management and/or performance fees when it comes to side pockets.
When a Cayman fund administrator decides to create a side pocket, the existing shareholders are most often allocated shares on a pro-rata basis in the new side pocket account. These allocated shares are unable to be redeemed until the fund manager sells the side pocket investment. Redemption of side pocket shares pocket can only be done when the assets in the pocket can be valued accurately.
The fund manager then has the flexibility to sell an illiquid asset on the manager’s own terms, and not just to satisfy an investor’s redemption request.
New shareholders have no entitlement to shares in the assets held in the side pocket. This is intended to protect the new investor from any over-estimation of the side pocket’s valuation and allows them to enter the fund based on the fair value of the remainder of the fund’s liquid portfolio.
When properly executed, side pockets can be a useful tool that helps level the playing field for investors in hedge funds with liquidity issues. Creating a side pocket is not a magic bullet for funds with liquidity issues and there are operational and ethical issues that must be considered before creating one. The fair treatment of all investors in the fund should be the main concern.