Side Pocket

What Is a Side Pocket?

A side pocket is a type of account used in hedge funds to isolate less secure or illiquid assets from additional liquid investments. Typically, when a position enters a side pocket account, just the current participants in the hedge fund are qualified for a share of it. Future investors won't receive a share of the proceeds should the resource's returns become realized.

Overall, side pocket accounts have a long history in the hedge fund industry. They are legal and sound investment accounts, however regulatory specialists closely monitor them. These accounts and their purposes must be completely recorded for investors. Likewise, hedge fund managers are closely looked for the proper valuation of these assets to produce fair management compensation.

How a Side Pocket Works

Looking like single-resource private equity funds in structure, side pocket accounts are solely utilized in the hedge fund industry by hedge fund managers. Their purpose is to separate illiquid, difficult to-value, and frequently exceptionally dangerous assets from other, more liquid assets. The illiquid assets in these side pocket accounts incorporate investments, for example, real estate, collectibles, over-the-counter (OTC) stocks, stocks with very low trading volume, stocks delisted from exchanges, and private equity investments.

The assets of a side pocket account are recorded on a fund's books, however they are followed separately. Their accounting and valuation systems are remembered for the fund's investment prospectus. At the point when a side pocket account is made, an investor in the fund receives a pro-rata investment in the side pocket account.

Side Pockets and Illiquidity

Holding illiquid assets in a standard hedge fund portfolio can cause a great deal of complexity when investors wish to take distributions or leave the fund altogether — another justification for setting these assets in a separate account.

Investors who leave the hedge fund will most likely be unable to recover their side pocket investment from the fund right away. Notwithstanding, they receive a share of the value when the assets are liquidated or moved to the general fund. Typically, just the most distressed assets, like delisted shares of a company, receive this type of treatment.

Putting side pocket funds untouchable decreases too many early exits from the hedge fund, allowing fund managers to balance the need to meet investor recoveries with that of keeping up with sufficient capital for the fund to appreciate.

Side pocket accounts have been the target of various investigations. These investigations have mostly centered around managers who have overvalued the illiquid assets in the side pocket accounts. Overvaluing these assets prompts gathering higher management fees from investors. At times, managers have additionally misappropriated the funds from side pocket accounts to the disadvantage of investors.

In 2011, fund manager Lawrence Goldfarb and his private investment fund Baystar Capital II provided a leading case of side pocket-related malfeasance. The Securities and Exchange Commission (SEC) charged Baystar for fraudulent reporting and misappropriated funds from a side pocket account.

In this case, Baystar reported lower returns than were earned from the account, utilizing funds to invest in other substances that he had an economic interest in, and furthermore for personal expenses. Without conceding or denying the SEC protest's charges, Goldfarb agreed on March 1, 2011, to pay more than $14 million in disgorgement and prejudgment interest fees as a last judgment to the case.

Side pocket accounts were likewise refered to on account of Steven Cohen's SAC Capital Advisors, which was accused of insider trading in November 2013. The side pocket accounts were not the focal point of the SEC's investigation and not the justification behind the firm's closure in 2016. In any case, the requirement for a significant time frame to close the firm was allowed in view of the difficulty in esteeming and liquidating side pocket investments.

Features

• These may incorporate oddball or speculative investments that don't be guaranteed to fit the fund's core command or strategy and may remember holdings for real estate, digital currencies, derivatives, or commodities.
• Side pocket holdings will just benefit current fund participants, and new contestants won't receive any benefits, nor losses, from those holdings.
• Side pockets are a type of accounts utilized in hedge funds used to hold illiquid, difficult to-value, and frequently exceptionally unsafe assets, isolating them from the fund's other core investments.