All things considered, side pocket accounts are not new to the hedge fund business. Although they are legitimate and trustworthy investment accounts, regulatory bodies keep a tight eye on them. Investors need a thorough record of these accounts' activities.
What Is a Side Pocket
In hedge funds, a side pocket account type is used to separate more liquid investments from riskier or less liquid assets. Generally, only the active hedge fund participants are entitled to a portion of a position after it enters a side pocket account. In the event that the asset's returns are achieved, future investors will not get a portion of the revenues.
All things considered, side pocket accounts are not new to the hedge fund business. Although they are legitimate and trustworthy investment accounts, regulatory bodies keep a tight eye on them. Investors need a thorough record of these accounts' activities. Hedge fund managers are also rigorously observed to ensure that these assets are valued appropriately in order to produce appropriate management remuneration.
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KEY TAKEAWAYS
- Side pockets are a type of accounts used in hedge funds used to hold illiquid, hard-to-value, and often highly risky assets, separating them from the fund's other core investments.
- These may include one-off or speculative investments that do not necessarily fit the fund's core mandate or strategy and may include holdings in real estate, cryptocurrencies, derivatives, or commodities.
- Side pocket holdings will only benefit current fund participants, and new entrants will not receive any benefits, nor losses, from those holdings.
How a Side Pocket Works
Side pocket accounts, which have structural similarities to single-asset private equity funds, are utilized only by hedge fund managers inside the hedge fund business. Their function is to distinguish between other, more liquid assets and illiquid, difficult-to-value, and sometimes extremely dangerous assets. Investments including real estate, antiques, over-the-counter (OTC) equities, stocks with very little trading activity, companies that have been delisted from exchanges, and private equity investments are among the illiquid assets held in these side pocket accounts.
Although they are tracked independently, the assets of a side pocket account are noted on a fund's records. The investment prospectus for the fund contains information about their accounting and valuation procedures. An investor in the fund receives a pro-rata investment in the side pocket account upon creation of the account.
Illiquidity and Side Pockets
Another reason to keep illiquid assets in a separate account is that holding them in a normal hedge fund portfolio can become quite complicated when investors want to collect payouts or exit the fund entirely.
It's possible that investors who quit the hedge fund won't be able to get their side pocket money back right away. When the assets are sold or transferred to the general budget, they do, however, get a portion of the proceeds. This kind of procedure is often reserved for the most troubled assets, such as delisted firm shares.
By making side pocket money off-limits, fund managers are better able to strike a balance between meeting client redemption requests and preserving sufficient capital for the fund's growth. This helps minimize the number of early hedge fund withdrawals.
Numerous investigations have focused on side pocket accounts. The managers who inflated the illiquid assets in the side pocket accounts have been the primary target of these probes. Investor management fees increase when these assets are overvalued. To the disadvantage of investors, managers have occasionally also embezzled money from side pocket accounts.
Pros
- Separates illiquid and liquid assets
- Shields hedge fund returns from distressed assets
- Simplifies accounting and administration
- Limits fund redemption
Cons
- Delay in redemption
- Prone to misappropriation
- Can be open to incorrect pricing
- Not shared by new investors
Examples of Side Pockets
One of the best examples of side pocket-related fraud was shown in 2011 by fund manager Lawrence Goldfarb and his private investment firm, Baystar Capital II. Baystar was accused by the Securities and Exchange Commission (SEC) of filing false reports and stealing money from a side pocket account.
In this instance, Baystar claimed lesser returns from the account than really occurred, as he used the money for both personal spending and investments in other companies in which he had an economic stake.On March 1, 2011, Goldfarb consented to pay over $14 million in disgorgement and prejudgment interest fees as a final judgment in the matter, without acknowledging or disputing the charges in the SEC complaint.
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