Tag Archives: PIPE

Hedge Fund Side Pocket Investments

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
  • PIPEs
  • 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.

Please feel free to contact us with any questions.  Other articles which relate to this subject include:

Hedge Fund PIPE Transactions

What are PIPE transactions?

The SEC has defined a PIPE transaction as follows:

“PIPE” stands for “private investment in public equity.” In a PIPE offering, investors commit to purchase a certain number of restricted shares from a company at a specified price. The company agrees, in turn, to file a resale registration statement so that the investors can resell the shares to the public. To the extent that they increase the supply of a company’s stock in the market, PIPE offerings can potentially dilute the value of existing shares.  (Source)

Hedge Fund Investments – PIPE transactions

PIPE transactions can be a part of a hedge fund investment strategy and in some cases a whole investment strategy. Generally hedge fund managers who focus on PIPE investments are hoping for a large exit strategy such as a reverse merger or a public offering.  Such managers have experience in the PIPE space and have concluded many PIPE transactions.

For such hedge fund managers, there are many considerations with regard to these investments including:

Structure – hedge fund managers who invest in PIPEs can be very creative when it comes to the structure of their hedge fund.  The fund can be structured as a private equity fund, a normal hedge fund or a combination.  A manager should discuss the options with his attorney.

Side Pocket Investments – based on the structure of the fund, the manager may want to institute side pocket investments.  Side pocket investments allow a manager to segregate certain illiquid or hard to value assets until a disposition of the asset.  A side pocket investment would be more likely in a normal hedge fund or a combination fund.  Many PIPE hedge funds have side pocket investments.

Lock-up – because of the recent market volatility and the rush for redemptions, many managers are re-examining their lock-up periods.  For hedge funds with investments in illiquid securities, this is especially important from a cash management perspective.  The manager should spend some time discussing the lock-up with the attorney; the lock-up should generally be a little longer than the expected time horizon of the investments.  For example, if the fund will make PIPE investments which is expected to have an 18 month duration then the lock-up should not be only a year.

Investment program – the manager will need to define the areas and limits of the investment program in the offering documents.  While broad and vague investment programs have generally been acceptable, it is likely that investors are going to want to know more specifics of the program going forward.  The manager will want to describe what types of companies it will invest in, what types of securities it will recieve (common stock, warrants, and convertible instruments), what the manager looks for in a potential company/ management team, what is the expected duration of the investment, among other items.  Of course the manager should include a component dealing with its risk management procedures as well.

Fee range – generally PIPE investments will follow the standard fee range for hedge funds.  The manager may choose to institute a higher management fee.  Additionally, thought should be given to the fund’s expenses in making investments.

Risks and Other Considerations for PIPE hedge funds

Liquidity – the PIPE securities which the hedge fund owns are not liquid.  Accordingly the hedge fund manager will need to closely manage the hedge fund’s cash.  While manager used to be able to rely on some sort of credit facility to take care of the fund’s cash management needs, this is not as likely to be the case in the tight credit markets today.

Valuation – like many hedge fund strategies the central concern for hedge funds with a PIPE program is going to be valuation.  The fund will hold some of the more illiquid assets – restricted securities which cannot be sold for a certain amount of time.  As with other programs with liquidity issues, the basic methods of valuation include: (1) book value; (2) outside valuation agent; or (3) by formula. There are advantages and disadvantages to each one of these methods and if you need to have a valuation methodology your lawyer will be able to help you to decide on one of theses methods.  A manager should also discuss the valuation with the administrator and the auditor as well.

Contractual risk – there is a risk that the underlying company would not honor the contractual provisions of the PIPE transaction.  In such a case it is likely that a hedge fund would seek to enforce its contractual rights through the court system which is both time consuming and expensive.

Regulatory risks – there are various regulatory risks associated with PIPE investments.  Central is an investigation into the PIPE transaction by the SEC.  As discussed in greater depth below, the SEC is very interested in PIPE transactions. There is also the risk that, as a reseller of securities, the fund may deemed to be an underwriter which would subject it to further regulation – the hedge fund manager and attorney should discuss this issue.

Due Diligence – the fund managers must conduct research and due diligence on the underlying company.  This type of research is typically more involved than many hedge fund investing strategies.  If the manager will be conducting in-person reviews of the company and the company’s management team, the manager should discuss this with the hedge fund attorney so that the offering documents explicitly state that such expenses be paid by the fund instead of the management company.

SEC on PIPE transactions

The SEC has taken many enforcement actions over the years on PIPE transactions.  Hedge fund managers should be especially aware of this because the SEC is on the lookout and the fines are stiff.  Below are a few of the many actions the SEC has taken to stop abusive PIPE transactions:

SEC v. Deephaven Capital Management, LLC (release)

In this case a hedge fund manager traded on insider information.  The manager received information that a PIPE transaction would be announced and sold short the publicly traded securities of the company.  When the PIPE transaction was announced, the stock went lower and the fund made large gains.  The manager had to disgorge the profits and was subject to a fine.

SEC v. Joseph J. Spiegel (release)

This case represents a classic PIPE case – the hedge fund manager agreed to participate in a PIPE transaction and then sold the company’s stock short, against representations that he would not.  When the restricted stock became unrestricted, he used this stock to cover his previous short.  The manager had to pay a fine and was also barred from association with any investment advisor for five years.

SEC v. Jeanne M. Rowzee, James R. Halstead, and Robert T. Harvey (release)

In this case fraudsters promoted investments in PIPE transactions but never invested the money and instead spent lavishly on themselves.  In classic Ponzi Scheme fashion, the fraudsters solicited new investors to pay off the original investors.

As always, please feel free to contact us if you have any questions.  Additional resources which relate to this post include:

Hedge Fund Analyst Fined for Insider PIPE Trading

According to a SEC litigation release, a hedge fund analyst was fined $317,000 for engaging in insider trading with regard to a PIPE investment.  PIPE transactions are subject to close scrutiny from the SEC.  In this instance the fund which the analyst worked for established a short position in a company which was completing a PIPE transaction.  Evidently the reason the fund established the short was because of inside information about the deal from the analyst.  The SEC release can be found here.

Litigation Release No. 20784 / October 20, 2008
SEC v. Brian D. Ladin et al., Civil Action No. 1:08-CV-01784 (RBW) (D.D.C.)

SEC Charges Former Hedge Fund Analyst with Improper Trading

The Securities and Exchange Commission today charged Brian D. Ladin, a former analyst for Bonanza Master Fund Ltd. (“Bonanza”), a Dallas-based hedge fund, with improper trading in the U.S. District Court for the District of Columbia. Ladin, without admitting or denying the allegations in the Commission’s complaint, agreed to settle charges that he engaged in unlawful insider trading in connection with a 2004 “PIPE” (an acronym for private investment in public equity) offering conducted by Radyne Comstream Inc. As detailed below, Ladin agreed to entry of a final judgment imposing an injunction and ordering him to pay $330,427, consisting of $13,427 in disgorgement and prejudgment interest and a $317,000 civil penalty.

The Commission’s complaint alleges, among other things, that Ladin accepted a duty to keep the offering information confidential. The Complaint further alleges that Ladin, on the basis of the material, non-public PIPE information, presented an investment in Radyne to Bonanza, resulting in Bonanza establishing a 100,000 share short position in Radyne stock. The Commission’s complaint further alleges that Ladin, in signing the offering’s stock purchase agreement on behalf of Bonanza, represented that Bonanza did not hold a short position in Radyne common stock when he knew, or was reckless or negligent in not knowing, that Bonanza held a short position in Radyne’s common stock.

Ladin consented to the entry of a final judgment (i) permanently enjoining him from future violations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Section 17(a) of the Securities Act of 1933; (ii) ordering him to pay $10,895 in disgorgement, along with $2,532 in prejudgment interest thereon; and (iii) ordering him to pay a $317,000 civil penalty. Bonanza and its investment adviser, Bonanza Capital, Ltd., consented to the entry of a final judgment ordering them, as relief defendants, to pay a total of $371,429 in ill-gotten gains derived from Ladin’s unlawful conduct (and prejudgment interest thereon).

For more information on this subject, please see:

  • Hedge Funds and PIPE Transactions

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