What’s in Your Side Pocket?
According to Dechert partner David Vaughan, side pockets are "probably one of the biggest trends now" among hedge funds that utilize multiple investment strategies.
Whatís a side pocket?
Say a hedge fund manager invests in a private equity-esque investment, such as a start-up company that has a three-year horizon. To keep it safe from having to be liquidated prematurely to meet redemption demands, the investment can be placed in a "side pocket." Investors in the fund who then redeem their interests will receive cash proceeds for their pro rata interest in the fund, except for the side-pocketed part. They will retain a pro rata interest in the side pocket investment, but wonít receive cash proceeds, if any, from that interest until a "realization event" occurs on the investment (thatís when the fund "realizes" a profit or loss in the investment, such as when a private company is acquired or goes public).
What types of investments go into side pockets? Basically, anything that has a long-term investment horizon. The "classic example," said Managed Funds Association senior legal counsel Stephanie Pries, speaking at last weekís SIA hedge fund conference, is investments in private companies, "companies where thereís no public market for their securities." Her co-panelist, Mayer, Brown, Rowe & Maw partner Michael Butowsky, said that often equity kickers and warrants are put in a side pocket.
Eisner partner Nicholas Tsafos, in an interview, noted that securities such as debt or convertible notes that are issued to accredited investors by a public company and that do not trade on an exchange could be fair game for side pocketing.
Managers typically disclose the existence of side pockets in a fundís offering memorandum and private placement memorandum, as well as in a domestic fundsí partnership agreement, said Tsafos. According to statistics presented by Morgan Stanley managing director Craig Abruzzo, presented at the SIA conference, the typical side pocket provision seen in hedge funds launched in 2005 provided that up to 20 percent of the fundís assets may be placed in a side pocket. Thatís up from the typical ten percent side pocket seen in 2004.
"Twenty percent could be a big number," noted Tsafos, who said percentages specified in side pocket provisions "go all over the place." And, he added, "Iíve seen a lot of partnership agreements and offering memoranda where they donít disclose an amount."
There can be good reasons not to set a limit: Letís say your fund has disclosed that it has a ten percent limit on the amount of investments held in the side pocket. Thatís just fine while youíve got illiquid assets in the side pocket that represent eight percent of the value of the fund. But what if one of the fundís limited partners withdraws capital, raising the relative value of the illiquid assets to 11 percent of the fund? You canít easily sell them (thatís the whole reason theyíre in the side pocket to begin with). And devaluing a security to get you under a limit is fraught with peril, as evidenced in the SECís case against Van Wagoner last summer (the fund company was sued for devaluing illiquid assets when it bumped up against the 15 percent limitation).
What ever you do, donít think of side pockets as a way for hedge funds to "sort of punt" on valuation, as one panelist at the SIA conference put it. Regardless of whether a non-marketable asset is placed in the side pocket, said Tsafos, it still needs to be valued. Think about it ó how else can you charge fees on side-pocketed assets or include them in performance calculations?
Of course, added Tsafos, there are "a lot of variables" that go into valuing illiquid securities. For example, simply valuing a non-marketable security at cost may not work if significant market events have occurred after purchase, or if revenues or sales suggest an upward or downward revision. Tsafos emphasized that these issues are the same regardless of whether or not a non-marketable security is in a side pocket.
Speaking of fees, Tsafos noted that there are variety of ways that funds can structure fees on the side pocketed assets. One way, he said, might be to charge a different rate on the side pocketed assets, or to apply the performance fee rate only on realized gains.
Still another word of caution: according to one law firm partner, SEC examiners have been asking whether the use of side pockets somehow raises fiduciary issues for advisers.
What might they be concerned about? Examiners may question whether there is any favoritism being shown to new versus existing investors. They may question whether exiting investors that have had to leave capital in the side pocket have been properly informed of that fact. And, they may question whether any side pocketed securities are in fact "shady" or questionable investments, that perhaps at one point have been affiliated with or owned by the adviser.