What are side pockets?
Side pockets are devices used by some funds (usually hedge funds), as a means of addressing issues arising where certain assets within the fund’s portfolio become illiquid or comparatively hard to value.
Such instances are problematic to the fund’s performance in view of the fact that where an asset is illiquid, this may affect the ability of the fund to realise the asset (or realise the asset at a reasonable price) in order, among others, to meet redemption obligations. On the other hand, in cases where an asset cannot be valued accurately, the risk arises that prices for any subscriptions and redemptions in respect of the relevant portfolio of the fund will not accurately reflect the fair value of the relevant asset with the resulting concentrative and dilutive effects for investors.
How do side pockets operate?
Side pockets allow the fund to separate the illiquid assets from other more liquid investments, instruments which are hard to value from others whose value is determined more easily. These problematic assets are transferred into a specially created new class (side pocket) within the fund. In this manner, the problematic assets are separated from the main pool of more liquid investments allowing for continued issue and redemption of units in the liquid pool.
This process also entails the conversion of the corresponding fund units held by investors into ‘side pocket units’. In the case of a PIF set up as a multi-fund scheme having troubled assets within a sub-fund, a side pocket can only be created within and will only affect the unit holders of that particular sub-fund. This is an important principle which is corollary to the fact that the assets and the liabilities of each sub-fund cannot contaminate each other given that they constitute separate patrimonies at Maltese law. In such case, the PIF will be required to create and issue a new class of units within the sub-fund, and the troubled assets will be allocated accordingly. This re-allocation of assets to the new class of units will result in a diminution in the net asset value of the original classes of units.
The existing unit holders are allocated a pro rata holding in the new class of units constituting the side pocket and thus will continue to be exposed to the problematic assets. Having said this, future unit holders will not acquire any interest in the existing side pocket. On the other hand, such future unit holders will participate in any future side pockets that are established. Naturally, in the case that an investment enters a side pocket and subsequently is realised, only the unit holders in the particular side pocket will participate in that added valeu achieved through such realisation. In those cases whereby a problematic asset subsequently becomes liquid or capable of valuation, the PIF will normally have two options:
- redeeming such asset to the benefit of the unit holders in the side pocket;
- transfer such asset to the liquid pool of assets (and liquidate the side pocket as the case may be).
How are side pockets regulated under Maltese law?
On the 31st May 2012 the Malta Financial Services Authority (MFSA) issued a Guidance Note on the Use of Side Pockets by Collective Investment Schemes. The Guidance Note expressly states that it only applies to Professional Investor Funds (PIFs) which contemplate the use of Side Pockets in their Offering Memorandum. Presumably, PIFs whose offering documentation does not foresee the possibility of the use of side pockets cannot make use of such mechanisms. Moreover, the Guidance Note establishes that retail schemes (whether UCITS or non-UCITS) established under Maltese law cannot use side pockets.
The Guidance Note also proves to be a useful instrument in that it provides some clarification as to what information about side pockets the MFSA would expect the offering documentation of a PIF to include. In fact, PIFs are required to provide the following information in a clear, fair and non-misleading manner:
- the instances whereby a side pocket may be employed;
- the policy for transferring assets to side pockets, including the nature of the assets that may be allocated to side pockets and the circumstances in which such allocations may be made as well as the procedure for the allocation of investments to side pockets;
- the policy and procedure to be followed by the PIF for transferring assets out of side pockets or for redeeming such assets as well as the procedure to be followed for the redemption or re-conversion of the units representing the side pocket;
- any limits on the size of side pockets, including the maximum percentage of the PIF or any of its sub-funds which can be allocated to side pockets in aggregate. In this respect, it is also useful to note that the Guidance note does not impose any restrictions as to the maximum percentages – in instances where this is the case, however this will need to be disclosed in the offering documentation;
- policies for the valuation of assets allocated to a side pocket. PIFs are expected to provide very detailed information on the methodology for the valuation of these types of assets, which valuation must be adopted in a consistent manner. In any case, the MFSA would ordinarily expect that once a decision has been made to create a side pocket, the assets to be allocated to the side pocket are to be valued at cost until circumstances are such that a revaluation can be made. Alternatively, the assets are to be valued at the latest available market price or at an even lower value;
- the fee structure relating to the class of units representing the side pocket. In this case, the MFSA would ordinarily expect management fees to be calculated on the basis of the lower of cost and fair value. As relates to performance fees, these cannot be crystallised before the problematic asset is disposed of or becomes liquid;
- relevant risk warnings, making it clear that assets allocated to a side pocket may be hard to value, or are illiquid, as may be the case. This will obviously lead to a situation whereby it is more difficult for a ‘side pocket’ investor to liquidate its investment when compared to the normal investor.
The Guidance Note cautions against the capricious use of side pockets. In fact, before resorting to such a mechanism, the Fund Manager managed is expected to consider managing the troubled assets from an operational risk management perspective. In so doing, the Fund Manager is encouraged to liaise with the Fund Administrator.
Side pockets and market practise
Side pockets are a useful tool which allows fund managers to isolate investments until market conditions improve. At that point, then, the previously problematic assets can be sold at prices that better reflect their intrinsic value, thereby limiting losses to the fund and protecting fund investors in the process.
However, there is evidence that side pockets have been abused in the past.[1] For example, there exists evidence that during the financial crisis of 2008, many assets held by hedge funds became difficult to sell for a reasonable price. At the same time, many investors requested redemptions of their investments, a factor which created a high level of illiquidity within the funds. On their part, certain fund managers resorted to creating side pockets in order to avoid selling assets at extremely distressed prices. This led to a number of complaints being filed with a number of regulators around the world, especially because certain fund managers refrained from disclosing reasons for creating side pockets, or for assigning certain assets into side pockets. At the same time others continued to charge management fees on the higher and unrealistic net asset value.
On its part, the US SEC responded by assigning a number of its officials to investigate the manner in which side pockets were being used; particularly, whether fair values were being assigned to side pocket assets and also whether the information being disclosed to the affected investors through the offering documentation was accurate or otherwise. This has eventually led to a number of arraignments in frnt of the competent US authorities.
[1] January 2008 – Hedge Fund Standards: SEC Scrutinizing Hedge Fund “Side Pockets” by Kenneth M. Breen, Douglas Koff, Keith Miller, Barry Sher, Sean T. Haran, and Kevin Broughel.
