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 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.
Side Pocket Accounts and 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.
Risks of Side Pocket Accounts
In 2011, Lawrence Goldfarb and Baystar Capital Management provided a leading case of misappropriated funds from a side pocket account. The Securities and Exchange Commission (SEC) charged Baystar for fraudulent reporting in regard 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 matters and other expenses. Without admitting or denying the SEC complaint's allegations, Goldfarb agreed on March 1, 2011, to pay more than $14 million in disgorgement and prejudgment interest fees as a final judgment to the case. Side pocket accounts, which are sometimes used to invest in risky illiquid assets, were also cited in the winding down of Steven Cohen's SAC Capital Advisors, which was ordered to shut down in November 2013. 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.