What is a 'Side Pocket'

A side pocket is a type of account used in hedge funds to separate illiquid assets from other more liquid investments. Once an investment enters a side pocket account, only the present participants in the hedge fund are entitled to a share of it. Future investors will not receive a share of the proceeds if the asset's returns get realized.

BREAKING DOWN 'Side Pocket'

Side pocket accounts are exclusively used in the hedge fund industry by hedge fund managers. Their purpose is to separate illiquid, hard-to-value assets from liquid assets. The illiquid assets in these side pocket accounts include investments such as real estate, antiques, over-the-counter (OTC) stocks, stocks with extremely 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, but they are tracked separately. Their accounting and valuation mechanisms are included in the fund's investment prospectus. When a side pocket account is created, an investor in the fund receives a pro-rata investment in the side pocket account.

Illiquid Assets

Investors who leave the hedge fund may not be able to redeem their side pocket investment from the fund, but they still receive a share of the value when it gets realized. Usually only the most illiquid assets, such as delisted shares of a company, receive this type of treatment, because holding illiquid assets in a standard hedge fund portfolio can cause a great deal of complexity when investors liquidate their position. Overall, side pocket accounts resemble single-asset private equity funds in structure.

Side pocket accounts have been the target of numerous investigations and enforcements. These investigations have mainly been focused on managers who have overvalued the illiquid assets in the side pocket accounts, leading to higher fees from investors. In some cases, managers have also misappropriated the funds from side pocket accounts to the detriment of investors.

Lawrence Goldfarb and Baystar Capital Management provide a leading case of misappropriated funds from a side pocket account. The Securities and Exchange Commission (SEC) charged Baystar for fraudulent reporting in regards to a side pocket account. In this case, Baystar reported lower returns than were actually earned from the side pocket account and used the actual returns for personal use and other expenses.

Side pocket accounts were cited in the winding down of Steven Cohen's SAC Capital Advisors. The side pocket accounts were not the focus of the firm's required shutdown. However, the need for extended time to close the firm was granted because of the difficulty in valuing and liquidating side pocket investments.

Overall, side pocket accounts have a long history in the hedge fund industry. They are legal and credible investment accounts, but they are closely monitored by regulatory authorities. These accounts and their uses must be fully documented for investors. Additionally, hedge fund managers are closely watched for proper valuation of these assets to generate fair management compensation.

RELATED TERMS
  1. Air Pocket Stock

    A stock that experiences a sudden drop, similar to a plane hitting ...
  2. Hedge Fund

    An aggressively managed portfolio of investments that uses leveraged, ...
  3. Hedge Fund Manager

    The individual who oversees and makes decisions about the investments ...
  4. Illiquid

    The state of a security or other asset that cannot easily be ...
  5. Managed Account

    An investment account that is owned by an individual investor ...
  6. Hedge Accounting

    A method of accounting where entries for the ownership of a security ...
Related Articles
  1. Investing

    Hedge Funds Go Retail

    Find out how average investors are breaking into what was once reserved for the ultra rich.
  2. Managing Wealth

    When Introducing Illiquidity to Your Portfolio Makes Sense

    Find out when you should consider adding illiquid investments to your portfolio, such as real estate or locked-up investment funds.
  3. Financial Advisor

    Why Hedge Funds Are Not Living Up to Return Hype

    Hedge funds are supposed to produce better returns while protecting your investments from the downside. Here's why they are not living up to their purpose.
  4. Financial Advisor

    4 Reasons to Still Consider Traditional 2 & 20 Hedge Funds

    Find out why traditional 2 & 20 hedge funds are still worth considering as an investment, even though they have underperformed for the last several years.
  5. Investing

    Evaluating Hedge Fund Performance

    Most investors are aware of hedge funds, but many don't know the dirty details of this unique investment type.
  6. Investing

    6 Reasons Hedge Funds Underperform

    Understand the hedge fund industry and why it has grown exponentially since 1995. Learn about the top six reasons why the industry underperforms.
  7. Investing

    Hedge Funds: Higher Returns Or Just High Fees?

    Discover the advantages and pitfalls of hedge funds and the questions to ask when choosing one.
  8. Investing

    Taking A Look Behind Hedge Funds

    Hedge funds can draw returns well above the market average even in a weak economy. Learn about the risks.
  9. Investing

    Hedge Funds' Higher Returns Come At A Price

    Learn how hedge funds win big gains for investors - and why they sometimes lose.
  10. Investing

    Side-By-Side Management May Favor Hedge Over Mutual Funds

    Having your firm handle both investments can spell disaster for your returns.
RELATED FAQS
  1. How do hedge funds determine what assets to own?

    Learn about the various types of investments that hedge fund managers use, and explore basic hedge fund management trading ... Read Answer >>
  2. What is the purpose of a hedge fund?

    Find out what a hedge fund is, how it is set up and why it is different than other forms of investment partnerships like ... Read Answer >>
  3. Can hedge funds trade penny stocks?

    Discover the types of investments hedge funds can engage in, their primary goal, and the restrictions that preclude the average ... Read Answer >>
  4. Do hedge funds invest in private companies?

    Understand how fund liquidity and investment returns as required by investors affect hedge funds' decisions to invest in ... Read Answer >>
  5. What does a hedge fund do?

    Read how hedge funds differ from other investment vehicles and how their investment strategies make them unique and potentially ... Read Answer >>
Hot Definitions
  1. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  2. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  3. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  4. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  5. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
  6. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
Trading Center