Side Pockets in Hedge Funds: Structure, Benefits, and Risks

Side pockets in hedge funds serve as specialized accounts designed to manage the complexities of illiquid, hard-to-value, and high-risk assets. This in-depth exploration delves into the historical context, functioning, and the pros and cons associated with these unique financial instruments.

Side pocket accounts, unique to the hedge fund industry, provide a structured approach to handling assets that don’t align with a fund’s core strategy. Illiquid assets, such as real estate, antiques, over-the-counter (OTC) stocks, and private equity investments, find a home in side pockets. Resembling single-asset private equity funds in structure, these accounts maintain separate accounting and valuation mechanisms, detailed in the fund’s investment prospectus.

When a side pocket account is initiated, investors in the fund receive a pro-rata investment in the side pocket. This ensures a fair distribution of benefits and responsibilities associated with these specialized assets.

Illiquid assets, when commingled with more liquid investments in a standard hedge fund portfolio, introduce complexities during investor redemptions. Side pockets offer a strategic solution by holding assets that may not fit the fund’s primary mandate. Investors leaving the fund may face a delay in redeeming their side pocket investments. However, they are entitled to a share of the value when these assets are liquidated or relocated to the general fund.

While side pockets serve a legitimate purpose, some cases have raised concerns about their misuse. In 2011, fund manager Lawrence Goldfarb and Baystar Capital II faced charges from the Securities and Exchange Commission (SEC) for fraudulent reporting and misappropriation from a side pocket account. Goldfarb agreed to pay more than $14 million in disgorgement and prejudgment interest fees.

Another notable case involves Steven Cohen’s SAC Capital Advisors, charged with insider trading in 2013. Although side pocket accounts were not the primary focus, the extended time required to close the firm was influenced by challenges in valuing and liquidating side pocket investments.

Side pockets offer a strategic mechanism for hedge funds to manage illiquid and high-risk assets separately, shielding overall fund returns from distressed holdings.

Yes, regulatory authorities closely monitor side pockets to ensure transparency and prevent potential misuse. Fund managers must fully document these accounts for investor clarity and compliance.

No, side pocket benefits are exclusive to current fund participants. New investors do not receive any benefits or losses from these segregated assets.

Regulatory scrutiny acts as a safeguard against misappropriation. Violations, as seen in past cases, lead to legal consequences and financial penalties.