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Side Pockets As Hedge Fund Investments

What Are Hedge Fund Side Pockets?

Side PocketsSide pockets are accounts used in hedge funds to separate riskier or illiquid assets from more liquid investments. Typically, once a position enters a side pocket account, only the hedge fund’s present members are entitled to a piece of it. If and when the asset’s returns are achieved, future investors will not receive a portion of the revenues.

In the hedge fund industry, side pocket accounts have a long history. They are legal and credible investment accounts, but they are closely monitored by regulatory authorities. For investors, these accounts and their uses must be fully documented. In addition, hedge fund managers are closely scrutinized to ensure that these assets are properly valued in order to generate fair management compensation.

In the United States, open-ended or closed-ended funds are not permitted to use side pockets.  Only hedge funds are permitted to use this tool. Most countries leave it up to the respective fund managers to determine regulatory oversight.   However, they do require that the use of tools like the side-pocket be disclosed in the fund documents.

Special Situation Investments

A common issue for hedge funds is their investors’ requirement for frequent exit avenues.  This results in a fund’s need to maintain liquid holdings. Many hedge funds are formed as open-ended investment vehicles.  This gives investors the opportunity to request the redemption of their shares at regular monthly, quarterly, or yearly intervals. However, a fund is required to have a cash or near-cash reserve to accommodate redemption demands. Unfortunately, cash or near-cash is unlikely to deliver the excellent returns anticipated by hedge fund investors and management. As a consequence, some funds add Special Situation Investments to their typical portfolios. For example, bankruptcies, re-organizations, liquidations, tender offers and spin-offs,

Problems presented by special situation investments

  • Difficult to value – Special Situation Investments are, by definition, difficult to price correctly until a liquidity event occurs.  For example, a public offer, takeover, liquidation, or sale. If a Special Situation Investment is included in a fund’s general portfolio, it can only be valued at the base purchase cost or at the fund manager’s assessment, rather than at a stated market price. This will cause the computation of the fund’s net asset value to be distorted.
  • Uneven risk exposure – Some investors withdraw their investments in a fund that contains a Special Situation Investment in its general portfolio.  This results in the remaining investors having a disproportionately high stake in the fund’s illiquid, non-marketable assets. Consequently, a fund as a whole may be in compliance with its investment restrictions.  These restrictions apply to the holding of non-marketable investments as expressed as a percentage of the fund’s net assets.  However, redemption monies will be taken from the fund’s liquid portion of the portfolio.  The net effect results in non-redeeming investors’ exposure to the fund’s non-marketable investments exceeding such a percentage level.
  • Difficult to assess management fees – Until a liquidity event occurs, any performance fee imposed on a Special Situation Investment will not be computed using a net asset value based on a stated market price.

Side Pockets as a Solution

Funds need to isolate their Special Situation Investments from their ordinary portfolios.  This allows them to achieve both investor fairness and accurate net asset value and performance fee calculations. These objectives can be accomplished via the use of side pockets.

A side-pocket is formed when specified assets (usually illiquid assets) in a fund’s portfolio are separated and circumscribed from the rest of the portfolio. Only investors who owned units on the record date are then eligible to receive a portion of the revenues from the sale of the segregated asset. In the long term, side-pocketing helps to

  • Stabilizes the net asset value (NAV)
  • Minimizes redemptions.
  • Protects the liquid investments if the illiquidity event occurs unexpectedly,
  • Safeguards retail investors’ interests – since all investors, even institutional investors, are treated equally, and redemptions are halted while the side-pocket is in effect.

A side-pocket is created when specific assets (mostly illiquid assets) in the fund portfolio are segregated and ring-fenced from the rest. Only investors who hold units on the record date are entitled to share the proceeds generated from the sale of the segregated asset. Side-pocketing helps stabilize the net asset value (NAV) and reduces redemptions in the long run. If the illiquidity event is sudden, side-pocketing provides a cushion to the liquid portfolio. Further, it protects the interests of retail investors, since all investors, including institutional investors, are treated at par, and redemptions are suspended while the side-pocket is in place.  (Source: law.ox.ac.uk/business-law-blog)

How Side Pockets Work

Side pocket accounts are structured similarly to single-asset private equity funds.  However, in the USA, they are restricted for use solely by hedge fund managers in the hedge fund business. Their objective is to isolate illiquid, difficult-to-value, and sometimes extremely hazardous assets from more liquid assets. Real estate, antiques, over-the-counter (OTC) equities, stocks with very low trading activity, stocks delisted from exchanges, and private equity investments are examples of illiquid assets in these side pocket accounts. A side pocket account’s assets are recorded on a fund’s records, but they are monitored independently. Their accounting and valuation processes are detailed in the investment prospectus for the fund. When a side pocket account is established, each Fund participant gets a pro-rata investment in the side pocket account.

Only investors who are invested at the time of the original purchase of a particular Special Situation Investment can share the profits or gains.  Or, if an existing holding of the fund, at the time such holding is characterized as a Special Situation Investment.  As a result, anybody who invests in the fund after the fund purchases or classifies an existing investment as a Special Situation Investment will not have an interest in that Special Situation Investment. In other words, Special Situation Shares may not be redeemed. Investors may, however, continue to redeem their interests in the fund’s liquid assets.

Side Pockets and Illiquidity

Holding illiquid assets in a normal hedge fund portfolio may add a layer of complication.  Particularly, when investors choose to collect payouts or quit the fund entirely.  This is yet another reason to keep these assets separate. Investors who quit the hedge fund may not be able to instantly redeem their side pocket investment from the firm. They do, however, get a portion of the value when the assets are liquidated or transferred to the general fund. Typically, only the most troubled assets, such as a company’s delisted shares, get this sort of treatment.  Putting side pocket money off-limits reduces the number of early withdrawals from the hedge fund.  This enables fund managers to meet the requirement to fulfill client redemptions.  At the same time, it offers flexibility to keep enough capital in the fund to appreciate and grow.

Numerous inquiries have been launched on side pocket accounts. These investigations have mostly targeted managers who overpriced illiquid assets. Overvaluation of these assets results in increased management costs levied on investors. Managers have also siphoned monies from side pocket accounts to the disadvantage of investors in rare situations.

Side Pockets and Special Situation Investment Limits

Because a Special Situation Investment cannot be appraised until the liquidity event occurs, investors are tied to an investment.  Further, they have no means of evaluating how well it is doing throughout the period it is held by the fund. An investor may redeem his or her investment, but only from the fund’s liquid assets. As a result, the investor is compelled to keep an interest in the Special Situation Shares, unable to entirely depart the fund for many years.

As a result, the fund will normally limit its holdings in Special Situation Investments. This applies to a single Special Situation Investment and to all Special Situation Investments made by the fund in aggregate. The limit established is usually a percentage of the fund’s net assets at the time of investment.  the purpose is to mitigate the risk of Special Situation Investments.   Such allocation constraints are typically between 10 and 20% for single Special Situation Investments and up to 40% for aggregate Special Situation Investments.

Final Words

The use of side pockets provides many benefits for investors.

  • Dilution – Interests in a Special Situation Investment are not diluted when other investors subscribe to the fund.
  • Over-exposure – Remaining investors are not left with a disproportionately large interest in illiquid investments if other investors decide to redeem out of the fund.
  • Value and fees properly realized – The fund’s net asset value and the performance fee owed to the fund manager will not be based on unrealized gains on assets valued at a price different than the specified market price.

(Sources: law.ox.ac.uk, thehedgefundjournal.com, & investopedia.com)

Up Next: What Is a Compensating Balance?

 Compensating BalanceA compensating balance is a form of collateral to be maintained with a lender that enables the borrower to secure a line of credit or installment loan.  It is a minimum balance that effectively acts as collateral and thus compensates the lender for the risk of making the loan. Individual loans are less likely to require a compensating balance than corporate loans. The restricted balance cannot be used by the borrower.  Also, it must be disclosed in the borrower’s notes to the financial accounts.

A compensating balance successfully shifts the risk-reward balance in the lender’s favor. The lender earns interest on the entire amount of the loan but often charges the borrower a lower amount of interest. This is frequently offered by bankers as a way to offer a lower interest rate on loans made to existing bank customers. If the compensating balance falls below the statutory minimum, the interest rate on the loan will increase proportionally.

The compensating balance is also known as an offsetting balance.  It is used to counterbalance the costs associated with extending and servicing the loan. The funds are required to remain in the non-interest-bearing account for the duration of the loan.  As a result, the bank is free to use the money elsewhere. In this way, both the lender and the borrower find an advantage.

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