Hedge funds are typically characterized by their focus on liquid assets capable of valuation at regular intervals for the dual purposes of determining the price at which investors subscribe to and redeem from the fund and determining the management and performance fees payable to the investment manager. However, an existing investment may sometimes become illiquid because it is de- listed/suspended/subject to litigation and therefore hard to value.
Side pockets allow for the segregation of illiquid or hard-to-value investments from a fund's portfolio of liquid investments. This has the important effect of allowing investors to continue to subscribe for and redeem shares and preserves 'potential' value for investors in the side pocketed assets.
The types of investments that are usually categorised as such include real estate, private equity, bankruptcies, re-organisations, liquidations and other distressed securities.
Typically, a side pocket is created for an illiquid investment at the discretion of the investment manager – either for a newly created opportunity or from an existing investment. Once identified as such, a portion of each investor's equity interest is converted to a new class or series of non-redeemable equity interests, representing the fund’s investment in the illiquid investment. Generally, only those investors actually invested in the fund at the time the side pocket is established are able to participate in the profits and losses of the particular investment allocated to the side pocket. Any follow-on investment or value realised, or the asset itself, will only be available for participation by those investors participating in the original side pocket investment.
Investors in a side pocketed investment are 'locked-up' indefinitely and their shares in respect of the investment cannot be redeemed until the investment is realised or otherwise becomes readily marketable (on sale of the side pocket investment or on the occurrence of an event whereby the investment becomes liquid or is deemed to be realised.
Why are side pockets used?
In circumstances where an investment of a hedge fund has subsequently become illiquid, the valuation, accounting, allocation and liquidity provisions tend to become inappropriate. For example:
1. If the illiquid investment or 'special investment' is included in the general portfolio of the fund it can only be valued at the base acquisition cost or the fair value as assessed by the investment manager, rather than at a quoted market price and so will distort the fund's net asset value.
2. If some investors redeem their interests in a fund which includes a special investment in its general portfolio, the remaining investors will hold a disproportionately large interest in the illiquid investment(s) held by the fund.
3. Any performance fee charged on the special investment would, until the occurrence of a liquidity event, not be determined by reference to a net asset value based on quoted market prices.
In order to achieve both fairness amongst investors and accurate net asset value and performance fee calculations, it is necessary to separate out the special investments from the general portfolio of the fund into 'side pockets'.