By Evan Judd, Director of Bell Rock Group
Side pockets are a useful portfolio management tool that have been around for a number of years, and offer measurable benefits to both investors and hedge fund managers. However, there are also some notable drawbacks as well as possibility for abuse that demand recognition before considering its use.
A side pocket is simply a separate bookkeeping account used by hedge funds to segregate illiquid or difficult to value assets, for the purpose of preventing the distressed assets from damaging the returns generated by more liquid, better-performing assets. Assets can be designated for assignment to a side pocket either at the time of purchase or at a later date should market conditions change. Designated assets are valued separately from the general portfolio of the fund. Distinct valuation, allocation, withdrawal and distribution provisions are applied to these designated assets without affecting the general portfolio of the fund. As a mechanism to store such distressed or illiquid assets, a side pocket provides unique flexibility for the fund manager to isolate specific investments until market conditions improve and asset sales can be realized at prices that better reflect their intrinsic value, thus protecting value for investors and limiting losses to the fund.
When using a side pocket, a pro-rata interest in the side pocket investment is allocated to each investor, with the respective capital account reduced accordingly. An investor can only redeem his interest in the side pocket when the assets are liquidated or reallocated to the main portfolio of the fund. This mechanism protects investors by limiting early redemptions to a pro-rata share of the main fund and by preventing a headlong rush for the exit, thus avoiding the last-man-standing scenario. Fund managers can also avoid forced sales at artificially or temporarily distressed prices. Additionally, it ensures that only existing investors, and not subsequent investors, benefit from the appreciation, or suffer from the further deterioration, of an illiquid side pocket investment.
Hedge fund formation documents should clearly specify the conditions that permit the use of side pockets. Recommendations for drafting the fund offering documents include:
a) Establishing clear provisions for what type of assets can be designated to a side pocket and under what conditions.
b) Establishing reasonable policies for valuation of side pocket assets.
c) Providing a 3rd party administrator with access to all information and relevant statements regarding side pocket assets.
d) Establishing clear limitations on treatment of side pocket asset distributions.
e) Limiting side pocket management fees to performance fees, calculated only upon final disposition of the illiquid assets (i.e., the fund manager should be prepared to forego management fees on investments held in side pockets).
Board directors and fund administrators should review any situation in which a fund creates a side pocket to assure its adherence to the provisions of the offering documents. All parties should be in complete agreement with the valuation methodology, and be fully prepared to justify and defend the side pocket asset valuations, especially in cases where those assets are eventually sold at a price substantially lower than cost of acquisition. New funds should carefully consider how to adequately disclose information about side pockets to investors and the rules that govern their use in order to avoid any possible dispute.
And disputes do occur. In recent years there have been a number of enforcement cases brought by the SEC involving the abuse of side pockets. The SEC, in March 2011, charged a San Francisco area hedge fund manager, Lawrence Goldfarb and Baystar Capital Management with concealing more than $12 million in investment proceeds that was owed to investors. According to the SEC’s complaint, Goldfarb and Baystar were able to defraud investors because one particular investment was maintained in a side pocket that provided limited visibility to investors. Goldfarb diverted the proceeds for other uses rather than paying the fund’s investors. None of his transactions were authorized by the fund’s partnership agreement or offering documents. The fraud was concealed for several years by providing investors with false account statements showing no gains had been realized in the side pocket investment. This falsely indicated that the side pocket investment had not distributed any profits to the fund, and investors were unable to determine that they were entitled to distributions. Goldfarb agreed to pay more than $14 million to settle the SEC’s charges.
Following resolution of this case, Robert Kaplan, former Co-Chief of the SECs Enforcement Divisions Asset Management Unit, stated, “Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. Hedge fund managers may not use side pockets to obscure their activities from investors. Hedge fund managers need to honor their obligations to investors, and investors should pay close attention to the discretion that managers wield over side pocketed investments.”
Such close scrutiny of side pockets should serve as a reminder for investors to keep a number of things in mind when conducting their due diligence of hedge fund documents:
- understand the conditions which allow the manager to place assets in a side pocket. How much discretion does the manager have, and is there any limitation as to percentage of total assets?
- understand the valuation policy and procedure for side pocket assets
- demand third party involvement in the valuation process to prevent self-marking of side pocket positions
- investigate whether investors have the ability to opt-in or opt-out of future side pocket investments at the time of initial or additional capital contributions
- require detailed, consistent, transparent reporting on a regular basis
Adhering to these recommendations and following the policies stated in the constituent documents should limit the potential for abuse, and provide a clear path for investors and fund managers alike for the proper treatments of assets designated for assignment to a side pocket. Investors and fund managers both would benefit from the inclusion of clearly defined controls that reflect industry best practice.
About Bell Rock Group. Bell Rock is a leading provider of highly skilled and professional independent directors who have over 60 collective years of industry experience in investment management, law, risk management and banking. We are experienced in the regulatory, legal and operational requirements in Cayman and other jurisdictions. Each Bell Rock professional acts on a limited number of boards to ensure that adequate time is available to deal with any and all matters that arise. Our professionals meet the criteria for regulated funds and provide a level of comfort to investors that true and independent oversight of fund activities is in place. Bell Rock is regulated by the Cayman Islands Monetary Authority (CIMA) under the Companies Management Law (2003) and is audited by a CIMA approved audit firm.
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