Author: Paul Daniels
Side pockets have long been part of the hedge fund toolkit, but they remain one of the least intuitive features for investors and, at times, one of the most operationally complex for managers and administrators. At their core, side pockets are accounting and legal mechanisms used to segregate illiquid or hard-to-value investments from a fund’s main, liquid portfolio. While conceptually straightforward, their impact on fees, expenses, ownership, and investor expectations is often underestimated.
A side pocket is a segregated account or class within a hedge fund used to hold investments that cannot be readily valued or liquidated. Such investments may include private equity positions, thinly traded securities, distressed debt, or other assets with long or uncertain realization timelines. When an investment is side-pocketed, only investors who were in the fund at the time of that event (and in some cases, only those who made specific elections to participate) take part in its economics, which means that participation in that investment is effectively frozen, with new fund investors typically gaining exposure only to the liquid portfolio.
From an accounting perspective, the side-pocketed asset remains on the fund’s books but is tracked separately. Investor ownership is originally calculated based on capital accounts at the time the side pocket is created, and that ownership generally does not change over time, even as investors subscribe to or redeem from the main fund.
Side pockets are designed to address a fundamental fairness problem in open-ended funds: how to offer periodic liquidity while holding assets that cannot be sold at fair value on demand. Without side-pocketing investments, redeeming investors could receive more than their fair share, or remaining investors could be left holding a disproportionate amount of illiquid risk. Side pockets isolate these assets, allowing the main portfolio to continue operating with normal valuation and capital activity mechanics.
In recent years, side pockets have also been used proactively rather than reactively. Hybrid strategies that blend public and private investments increasingly rely on side pockets as a way to pursue longer-term opportunities without suspending redemptions or launching entirely separate vehicles.
In practice, expenses, fees, ownership percentages and ongoing ownership are where side pockets present potential issues. Many managers charge routine fund expenses to the liquid pool in consideration of total investor balances inclusive of side pocket capital to maintain a fair allocation of expenses. However, after an investor redeems from the liquid pool, without a liquid balance against which to apply their share of expenses, funds may need to record those expenses as payables due from the investor upon realization of the illiquid investments.
Management and incentive fees also have the potential to create complexity. When charged to applicable side pocket investors, management fees can erode side pocket ownership interests over time relative to non-fee payers. This may conflict with typical investor expectations that side pocket ownership is “fixed” at the time of creation – both in participation and percentage – until realization. Incentive fees are a further consideration. In most cases, incentive fees on side pockets are deferred until realization, but approaches vary between funds and some managers may choose to look at the performance of side-pocketed investments over time despite the illiquid nature of the assets.
Once capital is allocated to a side pocket, investors are effectively locked in until the underlying investment is realized or written off. Investors may retain a residual side pocket interest long after “exiting” the fund, a fact that may be poorly understood until it is unfolding in reality. Investors often do not fully consider this outcome at subscription, only to realize later that they remain economically tied to a side pocket despite full redemption from the liquid portion of the fund.
These disconnects between investor expectations and economic reality reinforce why side pockets are widely viewed as operationally burdensome, even when they make sense economically and seek to create fairness under nuanced circumstances. The reality is that there is no single “right” approach. Whichever approach is taken where options exist, it’s more important to avoid ambiguity and accurately set expectations in the fund’s governing documents – especially as to how fees and expenses accrue over potentially long holding periods – than it is to judge the approach itself.
Side pockets are sometimes described as a hedge fund’s attempt to replicate private equity economics within an open-ended structure. Private equity funds, by contrast, typically treat all investments pro rata across the vehicle and avoid side pockets altogether. If illiquid investments are significant in size, a dedicated co-invest or SPV may provide the appropriate solution. If they are a predictable part of an investment strategy, a private equity fund may make sense from the outset. In sum, side pockets are very helpful in dealing with the unforeseen need to segregate assets in a hedge fund, but they can create confusion and unnecessary room for error when overutilized.
Side pockets should be approached thoughtfully from the outset. While they are designed to balance investor liquidity with illiquid investments, they have the potential to introduce meaningful complexity in the areas of accounting and investor relations if not planned for appropriately. For assistance with thinking through the various legal structures and fees and expenses treatment for your investment strategy where private and illiquid assets may play a role, your fund administrator can offer the value of their experience with the issues that may arise under varying hypotheticals. From there, once an approach is settled on, working with fund counsel to invest in carefully crafted fund document disclosures may save both you and your investors the potential frustration of mismatched expectations and unwanted outcomes.