Hedge funds have increasingly used a mechanism known as a side pocket to store illiquid or hard-to-value assets. Storing these assets in a side pocket has benefits for both investors and fund managers. However, in the past few months, the Securities & Exchange Commission has cracked down on the use of side pockets by hedge fund managers. The SEC found that certain managers had overvalued assets (allowing the manager to extract additional fees) and in one case, even misappropriated funds from a side pocketed investment. This article explores the issues surrounding the use of side pockets in private investment funds and suggests protections that both investors and fund managers should consider when creating rules related to the use side pockets.
What is a side pocket?
A side pocket is a mechanism employed by hedge funds to separate illiquid and hard-to-value assets from other more liquid assets. For example, when a hedge fund makes an investment in an illiquid asset, such as a stock that is traded over-the-counter or an interest in another private investment fund, it often stores these assets in a separate side pocket account. Other times, hedge funds will store distressed assets in a side pocket. This prevents the distressed assets from damaging the returns generated by more liquid, better-performing assets. The side pocket is generally formed by the creation of a separate bookkeeping account. Each investor is allocated his or her pro-rata interest in the side pocket investment, with his or her capital account reduced accordingly. An investor can only redeem his or her interest in the side pocket when the assets are liquidated or relocated to the general fund.
Side pockets benefit both investors and hedge fund managers. They protect investors by limiting early redemptions to a pro-rata share of the main fund and by avoiding the last man standing scenario. Additionally, they ensure that only existing investors, and not investors who subsequently join the partnership, benefit from the appreciation of an illiquid side pocket investment. But they are also advantageous to fund managers. By using side pockets, fund managers avoid forced sales at (artificially or temporarily) distressed prices. Also, the use of side pockets facilitates new investment in the fund without new investors having to take exposure to illiquid assets. And lastly, side pockets ease the administrative burden on fund managers.
Recent Enforcement Efforts Involving Side Pockets
Two recent investigations by the SEC have brought to light the improper use of side pockets.
In October 2010, the SEC charged two Georgia hedge fund managers with defrauding investors by overvaluing particular illiquid assets that were placed in a side pocket. Paul T. Mannion, Jr. and Andrew S. Reckles, on behalf of the Palisades Master Fund, LP, placed an investment made in World Health Alternatives, Inc. (WHA) into a side pocket to avoid taking a loss on the investment and ultimately preventing redemptions by investors. The hedge funds offering documents specified methods for valuing side pocket investments. The managers allegedly valued the WHA investment in a manner that was contrary to the stated policy, which resulted in an inflated value for the investment. As a result, the managers collected higher management fees than were appropriate.
More recently, the SEC charged a San Francisco based fund manager with misappropriation of distributions from a side pocket investment. Credit Suisse alumnus, Lawrence R. Goldfarb, transferred an illiquid, ~$9mm real estate investment made on behalf of Baystar Capital II, LP, into a side pocket. Rather than collecting distributions on behalf of investors, the distributions were paid into a separate (but invalid) entity solely controlled by Goldfarb. Ultimately, Goldfarb used the distributions for unauthorized purposes – investing in alternative real estate ventures and paying personal expenses. In total, Goldfarb swindled ~$16mm in distributions from the funds investors.
Ensuring Proper Use of Side Pockets
As Robert Kaplan, Co-Chief of the SECs Enforcement Divisions Asset Management Unit, stated:
Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets.
Hedge fund managers may not use side pockets to obscure their activities from investors. Hedge fund managers need to honor their obligations to investors, and investors should pay close attention to the discretion that managers wield over side pocketed investments.
How can private fund managers and investors ensure that they do not encounter similar problems with side pockets? Some hedge funds have addressed the issue by completely eliminating the use of side pockets. However, for investors and managers who still wish to employ this mechanism, below are some tips to consider when drafting offering documents and partnership agreements.
1) Establish reasonable policies for valuation of assets located in side pockets.
2) Establish limitations as to how the fund manager may use distributions from investments held in side pockets.
3) Provide a 3rd party administrator with access to all bank statements regarding side pocket investments.
4) Limit side pocket investment fees to performance fees, assessed only upon disposition of the illiquid assets (i.e., suspend management fees on investments held in side pockets).
Adhering to these, or similar, principles and following the policies as stated in a funds governing documents should limit abuse. Investors should be cognizant of how a fund manager plans to treat illiquid or distressed assets, including rules related to side pockets, prior to making an investment. Savvy investors will insist on strict controls that reflect industry best practices.