Side Pockets

Every night has a day lying ahead. Similarly, every financial crisis leads to the huge investment opportunities. Sometimes it is done by the development of new financial instruments. Side pockets is one such form of investment that has, of late, been used by the Hedge Funds and large financial institutions.

Let’s say a hedge fund had some investments that were not yielding good returns, courtesy the financial crisis. The company that were otherwise fundamentally sound, but had become victims of the financial crisis had almost become dead investments. As a risk averse investor, you were not interested in such investments and thus found no incentive to invest in the hedge fund. On the other hand, the hedge fund manager knew that the investment was good, but was only a matter of time and didn’t want to sell off the investment to book huge losses.

How does the hedge fund attract investors then? Assuming it has enough cash (or liquidity) to invest in new investments it would set aside these dead investments in a separate class as designated investments of the fund and would classify them as illiquid (for practical purposes, Long term) investments.

Since these investments have been removed from the normal class of the fund, this does not affect you as you won’t invest in dead investments and would have fresh investments for the fund.

But what does it do with these dead investments then. Say I am an risk aggressive investor and share the same view that these investments would give high returns in the future. I would then invest in these investments (which are classified in a separate class) and look forward for high returns in the long term. These are called Side Pockets.

Once designated, distinct valuation, allocation, withdrawal and distribution provisions are applied to such designated investments without affecting the general portfolio of the fund (and its applicable terms)

Since the markets have started recovering, Hedge Funds have started reporting huge unrealized gains on these side pockets and the risk aggressive investors (in our example, me) are getting better fund returns. Obviously, since these were a separate class, the risk averse investors (you) are not sharing these unrealized gains with me.

Side pocket provisions typically permit a fund manager to create a side pocket, if the fund manager feels it to be in the best interests of the fund and its investors. Generally, only investors that are investors at the time the side pocket is created are allocated a participating interest in such investments. Accordingly, investors that become investors after a side pocket is created will have no interest in such designated investment.