Understanding Side Pockets: Definition, Function, and Benefits in Hedge Funds

Side pocket accounts allow hedge funds to segregate illiquid and riskier assets. This protects the fund’s core investments from potential volatility. These accounts ensure that only current investors benefit from future asset returns, preventing new investors from sharing in potential gains or losses. Side pockets serve to simplify administrative processes by balancing fund and investor needs.

Side pocket accounts face scrutiny from regulators due to the risk of misappropriation and overvaluation by fund managers, which can lead to inflated management fees. A side pocket account’s assets are recorded on a fund’s book but tracked separately from other assets.

What Is a Side Pocket?

A side pocket is a type of account utilized in hedge funds to segregate riskier or illiquid assets from more liquid investments. Usually, once a position 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 should the asset’s returns become realized.

Side pocket accounts are well-established in the hedge fund industry and are legal and credible. They’re carefully monitored by regulators, and their uses must be documented for investors. Hedge fund managers must also ensure assets are correctly valued for fair management fees.

Fund manager Lawrence Goldfarb and his private investment fund, Baystar Capital II, presented an example of side pocket-related malfeasance in 2011.

How Side Pocket Accounts Work in Hedge Funds

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.

Using Side Pockets to Manage Illiquidity in Hedge Funds

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 faced investigations, mainly about managers overvaluing illiquid assets. Overvaluing these assets increases management fees, and sometimes managers misuse the funds, hurting investors.

Real-World Examples of Using Side Pockets in Hedge Funds

In 2011, fund manager Lawrence Goldfarb faced charges for side pocket-related misconduct. His investment fund, Baystar Capital II, was charged by the SEC for fraud and misuse of side pocket funds.

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. Goldfarb agreed to pay over $14 million in penalties on March 1, 2011, without admitting or denying the SEC’s allegations.

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.

The Bottom Line

Side pockets in hedge funds are essential tools for managing illiquid and risky assets separately from liquid investments, ensuring fund managers have a more efficient portfolio management tool. Only current investors benefit from side pocket accounts, as these holdings are excluded from new investor allocations, making it crucial for current investors to understand the impact of these assets on their returns. These accounts help hedge funds manage complex portfolios by preventing early investor exits that could destabilize the fund, thus maintaining capital for ongoing appreciation.

While useful, side pockets come with risks, including potential delays in redemptions and susceptibility to misappropriation or valuation errors. Thus, they are under close regulatory scrutiny. The Baystar Capital II case highlights the potential for mismanagement and emphasizes the need for investors to be vigilant about fund managers’ practices.