Overview of Side Pockets
In general hedge fund side pocket investments are illiquid investments which the hedge fund manager places into a side pocket account. Mechanically the side pocket account is simply an entry on the hedge fund’s books which is tracked separate from the liquid, non side pocket investments. The structure is 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 a follow-on investment to an investment in a side pocket account will also be placed in the side pocket. Hedge fund managers will usually place an outside limit on the amount of assets which can be placed in the side pocket investments, usually calculated as a percentage of the fund’s assets and based on the purchase price of the side pocket investment. There are potentially additional issues for side pocket accounts in a master-feeder structure which should be discussed by the hedge fund attorney.
The actual mechanics of the side pocket account will be discussed in the hedge fund offering documents. It is advisable that the manager discuss the side pocket provision with the administrator and the auditor as well to make sure that all of the service providers are comfortable with the mechanics of the account.
The following asset types are usually good candidates for side pocket accounts:
- Real Estate
- Thinly traded securities
- Private Equity investments
- Any follow-on investment related to the above
Reasons for the side pocket account
The main reason to have a side pocket investment is so that the manager does not get under or overpaid from a valuation before an investment is sold. 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 property at the end of a performance fee period. Because managers are paid a performance fee (or allocated gains) on unrealized as well as realized investments, there is the potential for the manager to overstate the hedge funds unrealized gains by overvaluing the piece of property.
Another characteristic of the side pocket account is that a withdrawing investor cannot receive any part of his investment which is in the side pocket account. This allows the manager the flexibility to sell an illiquid asset on the manager’s terms and not merely to satisfy an investor’s redemption request. Once the side pocket investment is liquidated, appropriate distributions are made to the investor which has made a previous redemption.
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