Corporate Finance & Securities

Hedge Fund Side Pocket Accounts

This is our fourth post in our series on understanding hedge funds. Today, we will be discussing hedge fund “side pocket accounts.”

Hedge Fund Side Pocket Accounts

Generally, a side pocket is an account that is established by a hedge fund to segregate certain assets or investments from the fund’s general portfolio. Often, side pockets are used to hold less liquid securities such as real estate and private equity investments. Hedge fund formation documents may specifically permit the use of side pockets, which are used by fund managers to isolate investments often until market conditions improve and the assets can be sold at prices that better reflect their intrinsic value.

The side pocket account is simply an entry on the hedge fund’s books that is tracked separate from the non-side pocket investments.  The structure of a side pocket account is generally made to be flexible, so that an asset can be deemed a side pocket asset at any time–either at the time of purchase or at a later date. Typically, side pocket participation is based on the investor’s pro rata share of the entire fund.

Why have a side pocket account?

The main reason to have a side pocket investment is so that the manager does not get underpaid or overpaid from a valuation before the funds sells an investment.  For instance, if the manager held a piece of property in a non-side pocket account it would be difficult to find a valuation for the portfolio because the property is not easily valued and may be a substantial part of the fund’s portfolio.  Because managers are paid a performance fee (or allocated gains) on unrealized as well as realized investments, managers’ may be tempted to overstate the hedge fund’s unrealized gains by overvaluing the piece of property.  This might be particularly troublesome if the fund documents do not include a clawback provision for gains that end up being overstated.

How are shareholders affected by the creation of a side pocket?

Existing Shareholders: When a fund manager decides to create a side pocket, existing shareholders are generally allocated shares in the new side pocket account on a pro-rata basis. These shares cannot be redeemed until either the fund manager realizes a portion or all of the side pocket investment.

Redeeming Shareholders: If a shareholder decides to redeem or partially redeem his shareholding from a fund that holds an illiquid asset, the shareholder may not receive their full entitlement if the valuation of the asset was underestimated. The advantage of using a side pocket is that the proportion of the fund which is represented by the illiquid asset is only redeemed when it is capable of being accurately valued. This avoids prejudicing the redeeming shareholders and assures that the Net Asset Value of the fund is accurate.

New Shareholders: New shareholders will have no entitlement to shares in the side pocket holding the illiquid assets. This protects the new investor from any over estimation of the side pockets valuation and allows them to enter the fund based on the fair value of the remainder of the fund’s liquid portfolio.

Best Assets for Side Pocket Accounts

Illiquid assets are usually good candidates for side pocket accounts. Illiquid assets are those assets that are generally difficult to sell because there may not be many buyers interested in purchasing the asset. Common examples of illiquid assets include real estate, private equity investments, antiques, and securities that currently have low trading volume, such as those from companies delisted from the major stock exchanges.

If you’d like to learn more about hedge fund law, hedge fund management, or securities offerings generally, please contact us today.

Photo: Andreas Nilsson I Flickr

        


Collin Roberts

When he's not in the office, Collin enjoys IPAs and burgers at Latona Pub.


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