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 fair value Fair value Fair value is the price that buyers and sellers would agree upon in a normal, competitive market transaction. This market-based approach serves as the primary method for valuing hedge fund portfolios under generally accepted accounting principles (GAAP). 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 performance fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. 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 memorandum accountA special tracking account maintained by a limited partnership or limited liability company fund that records an investor's interests in specific illiquid investments without issuing separate securities, used to manage side pocket allocations. 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 incentive compensationPerformance-based pay structures that reward fund managers based on the fund's returns or achievement of specific targets. calculations until the investments are actually realized or their value becomes clearly determinable. This prevents managers from earning performance fees Performance fee A performance fee is compensation paid to a hedge fund manager based on the fund's investment profits, typically calculated as a percentage (commonly 20%) of returns above a specified threshold, subject to high-water marks and potentially hurdle rates. on uncertain valuations.

However, management fees Management fee Management fee refers to a recurring fee, typically calculated as a percentage of assets under management, that hedge funds charge investors to cover operational and administrative expenses regardless of fund performance. —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 fair value Fair value Fair value is the price that buyers and sellers would agree upon in a normal, competitive market transaction. This market-based approach serves as the primary method for valuing hedge fund portfolios under generally accepted accounting principles (GAAP). 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: Section 409ATax code provision requiring immediate income recognition of deferred compensation when no longer subject to substantial risk of forfeiture. of the Internal Revenue Code (which became relevant in 2005) and Section 457ATax provision requiring immediate income recognition of deferred compensation from nonqualified entities when no longer subject to substantial risk of forfeiture. (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 management fee reserveA portion of capital held back from redemption proceeds to ensure payment of ongoing management fees on illiquid investments. 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 deferred compensationCompensation arrangements where payment is postponed until a future date, often subject to specific tax treatment and reporting requirements. 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 co-investmentsInvestment arrangements where fund managers invest their own capital alongside investor funds, aligning interests and demonstrating confidence in investment decisions. 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, funds of funds, 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 net asset valueThe total value of a fund's assets minus its liabilities, divided by the number of outstanding shares or units..

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 slow-pay mechanismsContractual provisions that delay the timing of investor redemption payments for specified periods, allowing fund managers to manage liquidity from valued but relatively illiquid assets without segregating them in side pockets. 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. Slow-pay mechanismsContractual provisions that delay the timing of investor redemption payments for specified periods, allowing fund managers to manage liquidity from valued but relatively illiquid assets without segregating them in side pockets., 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.