Side Pocket

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21 Aug, 2024

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A Side Pockets in finance refers to a segregation technique to separate illiquid assets from others and place them in a pocket. It is primarily utilized in hedge funds. The sole purpose of this approach is to distinguish illiquid funds from quality investments.

Apart from hedge funds, side pocket investment is also visible in debt and equity funds. It further divides the net asset value (NAV) into two parts. Therefore, a separate accounting technique is applied to those assets that yield different return rates. However, the wrong segregation methods can also lead to poor returns.

Side Pocket Meaning

Side pocket refers to the accounting technique where fund managers slip illiquid (or poorly performing) assets into a pocket. They are separate from the liquid and quality assets.
They are a major part of the hedge and mutual funds. Also, the net asset value of these assets is different from the other assets.
If investors leave the hedge fund in between, it is impossible to recover them immediately. However, a small part of it can be allotted to them if they yield positive returns.
The major benefit of this pocket is that investors do not lose their NAV.

How Does Side Pocket Work?

Side pocket investment has wide popularity among hedge fund managers that segregate illiquid funds from others. It tries to separate the riskier funds from those yielding good returns. Any downgrade in an asset leads to the shift of that asset into this pocket. So, if a few investments performed worse in the past quarter, the fund manager will treat them separately. As a result, the portfolio becomes efficient and has better allocation in terms of assets.

The mechanism or process of a side pocket hedge fund or mutual fund works with degradation. When a particular asset performs below average, it slips into these pockets. These illiquid investments include real estate, stocks performing poorly or delisting from the exchange, or some debt instrument. However, the NAV visible only belongs to the liquid assets. The investors owning this pocket account receive a pro-rata investment in return. Furthermore, they are recorded separately in the fund's book for better analysis. However, exiting from a fund unannounced can lead to a loss of funds in this pocket account.

If investors leave the hedge fund before maturity, they may be unable to redeem the assets under this pocket. At such times, the fund house allots certain shares from funds that might turn liquid in the future. However, this treatment is only possible in distressed assets that have a price lower than market value.

Likewise, the side pocket accounting treatment also differs by usual nuances. As illiquid assets bring higher risk and volatility issues, redeeming them into cash is tough. It can also fluctuate the overall returns of the portfolio. Therefore, a separate side pocket accounting approach allows a lesser number of early exits from the fund.

Examples

Let us look at some examples to comprehend the concept in the best way possible:

Example #1

Suppose Kevin is a fund manager managing more than a hundred portfolios of his clients. He has been in this field for more than 10 years. At the present stage, Kevin has delivered good service to the investors. Therefore, his business leaped the neighborhood states. However, in the past few weeks, Kevin noticed that a few funds needed to be performed accurately. In short, the returns he had expected to be had dropped down suddenly. Thus, to investigate this matter, Kevin analyzes the portfolios of John, Stacy, and Samuel.

During his analysis, he concluded that certain stocks were performing poorly, and it had further influenced the overall fund's performance. As a result, clients were also turning aggressive to the negative returns obtained. However, with observation, Kevin decided to shift these assets (stocks) to a side pocket hedge fund. Its main aim is to try to keep these illiquid assets separate. Thus, in the later stages, Kevin also listed that fund in the stock exchange.

After a few months, the portfolios of clients improved, and the fund performance of major investors also rose.

Example #2

According to a recent news update as of October 2023, the asset management firm H2O has made some cuts (reductions) to the valuations made in the side pocket account. They have downgraded the value by almost 70% as compared to last year's valuations. However, these reductions also vary depending on the different illiquid investments held.

Likewise, the revenues of Nephila Capital have also risen with the release of side pocket capital in the same year. In short, it has boosted the revenue figures obtained from insurance-linked securities (ILS) from $57 million to $74.1 million.

Pros And Cons

Following are the advantages and disadvantages of side pockets that exist in the hedge funds and illiquid assets owned under them:

Pros	Cons
It secures the interest of the investors residing in the hedge funds.	There can be redemption issues while withdrawing funds from these pockets.
Illiquid assets receive a separate treatment that avoids any influence on the portfolio.	It can be challenging to value the investments under this fund.
It protects the liquidity of the portfolio investment.	Unless the illiquid assets do not yield good returns, they cannot become a part of the liquid assets.
This pocket allows transparency in the fund allocation and risk exposure.	Investors need to know these pockets, which may only sometimes occur from the fund house's side.

Frequently Asked Questions (FAQs)

When did the concept of a side pocket originate?

In 2006, Roel Campos, the Commissioner of the Securities and Exchange Commission (SEC), stated that hedge funds try to hide poor-performing securities under a side pocket due to their influence on the fund's performance and valuation. Later, in 2017, a Wall Street Journal article also mentioned withdrawal requests from the flagship fund of Pine River Capital firm. In short, investors had to vote on the segregation of $90 million worth of illiquid funds.

Why are side pockets important for investors?

Following are the reasons why side pockets are important for investors and fund houses. Let us look at them:

● It helps in stabilizing the funds from many redemptions and exits.
● Separate segregation is made for illiquid funds.
● Mutual fund experts can treat them separately instead of written-off.

What is the difference between a side pocket and a mutual fund account?

The major difference between side pockets and mutual funds is that the former only includes poor-performing assets. However, the latter includes all categories of assets and not just illiquid assets.