What's in a Side Pocket? A Key Strategy for Modern Hedge Funds
By: Michelle Morgan, AdvancedAIS
Introduction by: Bo Howell, FinTech Law
Introduction
In the dynamic world of hedge fund management, handling illiquid assets presents unique challenges. The 2008 financial crisis highlighted the need for flexibility, giving rise to the side pocket - a tool designed to isolate illiquid investments, manage risk, and create opportunities for both fund managers and investors. Today, side pockets aren't just a relic of past market turbulence; they're an evolving mechanism helping funds attract diverse investors, streamline operations, and meet the growing demands for transparency and customization in fund structures. This article explores the history, operational considerations, and modern applications of side pockets, helping you navigate their role in fund management today and anticipate their potential in the future.
The Past
In 2008, many hedge funds held suddenly illiquid investments, often among a larger portfolio of liquid investments. The challenge was that nobody wanted to invest in a fund tainted by illiquid and potentially valueless assets.
Additionally, if most investors were to redeem their shares, the remaining investors would be left holding nothing but illiquid assets. Because of this, redemptions were often restricted or prohibited.
So, nobody could exit the fund, and nobody wanted to enter.
The solution, which was not new to the fund world but became prevalent due to the 2008 credit crisis, was the side pocket.
The fund essentially carved out illiquid investments from the regular portfolio. Each investor's pro rata share of the regular class was matched with an equivalent share of these illiquid investments, issued as new shares in a side pocket class now holding only those illiquid assets.
Managers could then attract new investors without discouraging them with illiquid investments or their impact on redemptions. Existing investors could redeem and not be hindered by redemption restrictions that would have been unfair to the remaining investors.
From a legal perspective, there was some contention post-2008, as many offering documents were silent on whether side pockets were allowed. As a result, side pocket language is now standard boilerplate in fund documents.
Managing Side Pockets
From a fund administration perspective, accountants needed to segregate the illiquid investments from the rest of the portfolio. They had to ensure they captured the market value—usually equal to cost or nil—at the time of the side pocket's creation. The side pocket class was typically not subject to the same operating expenses as the regular classes, although it might share some costs or have its own unique expenses. Management and performance fees could also apply, despite the lack of liquidity to cover them.
In general, there first needed to be a clear understanding of the rules. Then, a method was required to apply these rules, which meant having granular control over the general ledger income and expense items and how these were allocated to shareholders.
Most fund accounting platforms were not equipped to handle such intricacies. Workarounds often involved setting up an entirely new 'fund' on the accounting platform to represent the side pocket class. Depending on how expenses were allocated, spreadsheets and manual journal entries were sometimes necessary. Additional work was required to consolidate the main and side pocket classes into one set of financials for the legal entity.
Eventually, some of these illiquid investments became liquid again, allowing investors to redeem their shares and leading to the dissolution of the side pocket class or the investments' merging back into the main portfolio.
The Present
Today, the term 'side pocket' doesn't only refer to ring-fencing illiquid investments.
It can refer to segregating any investment or group of investments, with their revenues and expenses attributed to a specific class of investors. This term is often synonymous with 'carve-out,' though a true carve-out can imply the creation of a new legal entity. A side pocket refers to a separate class within an existing fund structure.
In addition to carving out illiquid investments, funds may also want to carve out investments that certain investors are prohibited from participating in, or to highlight specific strategies, or to manage risk.
Hedge funds have become much more sophisticated since 2008, when they typically held one portfolio of investments for the benefit of all investors.These days, instead of launching a new fund for a new strategy, managers may simply create a new class within an existing fund. While there will be additional operating costs associated with tracking a new class, these costs won't be as high as setting up an entirely new fund. The accounting will be slightly more complex, depending on whether the software can handle side pockets and their nuances easily.
Investors have also become more sophisticated and diverse over the decades, leading to the development of different fee structures for various fund classes. For instance, institutional investors, who typically make larger investments, can often negotiate lower fees. Investors willing to forgo liquidity and commit to a longer investment period may also secure lower fees. Arrangements where investors automatically benefit from reduced fees after a certain period are becoming more common. Managers may also tailor fee structures to align with other investor group characteristics such as tax circumstances, risk appetite, and administrative complexity.
From an operational perspective, this requires tracking each class separately and ensuring accurate fee calculations for each one. Modern fund accounting software can manage these complexities, including handling incentive fees subject to hurdle rates and/or high watermarks. Offering memoranda must clearly outline the fees that each class of investors will incur, particularly when multiple classes are involved. Transparency is crucial to avoid perceptions of inequity among investor classes and to comply with potential regulatory scrutiny.
Overall, offering classes with different fee structures allows managers to attract a broader range of investors while having different classes hold different investments can result in cost savings.
Conclusion
With the blending of private equity and hedge fund characteristics, pressure to minimize costs, and a more flexible approach to fund structures, side pockets, and carve-outs are here to stay. The only potential disadvantage is more complex accounting (which can easily be handled by the right fund accounting software platform). However, side pockets will remain an efficient and cost-effective tool that will continue to grow in use.
Curious about the role side pockets could play in your fund's strategy? Contact Advanced AIS or FinTech Law to discuss the nuances of fund structuring, regulatory compliance. and how side pockets might enhance your fund's flexibility and appeal to investors. Their teams specialize in helping fund managers navigate complex financial instruments and regulatory landscapes, bringing clarity and strategic insight to your legal needs.
About Titan
Titan is a cloud-based fund accounting platform designed by two professional accountants with experience in the fund administration industry. Frustrated by the limitations imposed by their previous software—especially with respect to carve-outs—they turned their frustrations into a wish list and developed the Titan Platform. To learn more, visit AdvancedAIS – Titan Platform.