Side pocket

Side pockets are special accounts that hedge funds create to hold investments that are hard to sell or value accurately. These accounts are kept separate from the fund's main investment portfolio. Hedge funds use this structure to solve important fairness problems that arise when they own assets that either lack clear market prices or cannot be easily sold.

When a fund holds these problematic assets alongside its regular investments, several issues emerge. First, it becomes difficult to calculate accurate share prices for investors. Second, it creates unfairness between different groups of investors. New investors might inherit exposure to risky, hard-to-value assets they never agreed to take on. Meanwhile, existing investors might not get when they try to leave the fund.

Side pockets address these problems by isolating the difficult assets. This separation ensures that only the investors who were in the fund when these assets were purchased bear the associated risks and potential rewards. It also allows fund managers to calculate based only on assets with reliable valuations, excluding the uncertain side pocket investments until they are actually sold or their value becomes clear.

The specific legal structure of a side pocket depends on how the fund itself is organized. Funds set up as U.S. limited partnerships or limited liability companies typically create a separate to track these investments. Funds organized as corporations usually issue a separate class or series of shares to investors who participate in the side pocket investment.

The side pocket may also include related positions, such as hedging arrangements or financing deals connected to the main illiquid investment. Since these investments are typically held until they can be sold or until a specific event occurs, the portion of an investor's account that gets converted into side pocket interests cannot be redeemed until that time comes.

A side pocket works as a barrier that separates a fund's illiquid investments from its liquid ones. This separation means that side pocket interests generally cannot be redeemed when investors request their money back.

Here's how the redemption process works: When an investor wants to withdraw their entire investment from the fund, they only receive the liquid portion of their holdings. The fund keeps the investor's side pocket allocation until the underlying illiquid investments are converted to cash or until their value becomes reliably assessable.

Once the side pocket investment is eventually sold, or when the fund determines that its value can be readily established, the segregated assets are released. At that point, they are reintegrated into the fund's main portfolio, and investors receive their share of the proceeds.

Side pocket investments create complex fee calculation issues. Funds typically exclude these investments from calculations until the investments are actually realized or their value becomes clearly determinable. This prevents managers from earning on uncertain valuations.

However, —which funds charge on an ongoing basis—continue to apply to side pocket assets. These fees are usually calculated using the lower of the original cost or current as the measurement method until realization occurs.

This fee arrangement creates potential tax problems for fund managers. Two specific tax code provisions became relevant here: of the Internal Revenue Code (which became relevant in 2005) and (which took effect in 2009). These rules restrict the ability to defer compensation payments. If management fees on side pocket assets are deferred until realization, they could trigger adverse tax consequences for the manager.

To solve these tax issues, funds typically establish a when they create a side pocket. This reserve is funded from the fund's general assets and ensures that managers receive timely payment of fees on side pocket assets without triggering the penalties under these tax code provisions.

Side pockets experienced a significant decline in use during the years following the 2008 financial crisis. Many investors began expressing preferences for alternative approaches rather than the traditional side pocket structure.

Instead of combining illiquid assets within an otherwise liquid fund structure, investors started favoring separate dedicated vehicles for less liquid investments. They also began requesting opportunities for targeted offered on an elective basis. These alternatives give investors more choice and control over their exposure to illiquid assets.

As a result of these changing preferences, side pockets are no longer the nearly universal feature they once were across all hedge fund types (except for the most liquid strategies). Today, they are primarily concentrated in specific market segments where achieving full portfolio liquidity is not realistically possible: distressed credit investing, , and hybrid strategies.

Funds that use side pockets typically limit how much of their total assets can be designated as side pockets. These limits usually range from 10% to 30% of the fund's total net assets. Alternatively, the limit might be expressed as a percentage of each individual investor's .

These limitations are generally measured and applied at the time a side pocket is established. This means that subsequent market movements or investor redemptions may cause the aggregate side pocket percentage to exceed the specified threshold from time to time. This temporary breach is typically acceptable under the fund's governing documents.

Funds that combine with side pockets often use them for distinct purposes. Side pockets are reserved for investments that cannot be reliably marked to market—meaning their current value cannot be accurately determined. , by contrast, are applied to assets that can be accurately valued but should not be immediately liquidated due to market conditions or other strategic considerations.