What Is a Side Pocket?

A side pocket is a type of account utilized in hedge funds to differentiate illiquid assets from more liquid investments. Once an investment enters a side pocket account, only the current 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 become realized.

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

The Basics of a Side Pocket

Resembling single-asset private equity funds in structure side pocket accounts are exclusively used in the hedge fund industry by hedge fund managers. Their purpose is to separate illiquid, hard-to-value, and often highly risky assets from other, more 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.

Key Takeaways

  • Side pockets are a type of accounts used in hedge funds.
  • Side pockets are used to hold illiquid, hard-to-value, and often highly risky assets, separating them from the fund's other investments.
  • Once an investment enters a side pocket account, only the current participants in the hedge fund are entitled to a share of it.

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 reason for placing these assets in a separate account.

Investors who leave the hedge fund may not be able to redeem their side pocket investment from the fund immediately. However, they receive a share of the value when the assets are liquidated or relocated to the general fund. Usually, only the most distressed assets, such as delisted shares of a company, receive this type of treatment.

Putting side pocket funds off-limits helps reduce too many early exits from the hedge fund, allowing fund managers to balance the need to meet investor redemptions with that of maintaining enough capital for the fund to appreciate.

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

Pros

  • Separates illiquid and liquid assets

  • Shields hedge fund returns from distressed assets

  • Simplifies accounting and administration

  • Limits fund redemption

Cons

  • Delay in redemption

  • Prone to misappropriation

  • Can be open to incorrect pricing

  • Not shared by new investors

Real World Examples of Side Pockets

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, using funds to invest in other entities that he had an economic interest in, and also for personal expenses. Without admitting or denying the SEC complaint's allegations, Goldfarb agreed March 1, 2011, to pay more than US$14 million in disgorgement and prejudgment interest fees as a final judgment to the case.

Side pocket accounts were also cited in the case of Steven Cohen's SAC Capital Advisors, which was charged with insider trading in November 2013. The side pocket accounts were not the focus of the SEC's investigation and not the reason for the firm's closure in 2016. However, the need for an extended time to close the firm was granted because of the difficulty in valuing and liquidating side pocket investments.