Asset Management Blog Development

HFMWeek Interview – Side Pocket Accounting Dilemma

Ted Ryan, founder, and president of RyanEyes, explains to HFMWeek how his firm is helping Hedge Funds and Private Equity Funds overcome the accounting challenges side pockets pose.

You can read the interview on HFM Connect Here: https://www.hfmconnect.global/posts/solving-hedge-funds-side-pocket-conundrum

As we discussed in our blog post “How Side Pockets are Used by Hedge Funds,” side pockets have exploded in popularity, however, in the age of increasing compliance, these accounts pose significant accounting and administrative challenges for financial service firms.

Side pockets are not only an ongoing issue for hedge funds in their day-to-day operations but also one for regulators, as they are giving side pockets far more scrutiny than they have in the past. To find out more about how one firm is helping hedge funds overcome these challenges, HFMWeek recently sat down with Ted Ryan, Founder, and President of RyanEyes.

HFMWeek (HFM): Can you give an example of how Side Pockets are challenging fund administrators and accountants?

Ted Ryan: Sure, let’s start with a genuine real-life example. A leading Hedge Fund has hundreds of investors with approximately 20 sidepockets created per month. For accounting, the increase in the use of side pockets has led to an increase in 20,000 new capital entries per month. Side pockets can have hundreds of investors and if each investor starts a month with 20 side pockets and 20 new side pockets are added in a month – and there is a loan against each side pocket, the number of ledger entries explodes by the thousands each month and compounds exponentially going forward.

This fund spends countless hours managing spreadsheets, handling calculations, and ultimately processing their monthly NAV; hopefully, they get the calculations correct and the 150MB spreadsheet doesn’t get corrupted along the way.

HFMWeek (HFM): Given the SEC has laid out plans to place hedge funds and private equity funds under greater scrutiny, with calls for greater disclosure, what are the challenges fund managers face from an accounting perspective?

Ted Ryan: Frankly, what was once an annual manual process has now become untenable, costing fund administrators and accounting teams countless hours. Unless automation is brought to bear on the record-keeping and reporting requirements including greater disclosure on fees and more record-keeping requirements on performance accounting departments will become inundated with maintaining spreadsheets and handling manual accounting tasks.

This means that the fund manager with even just a handful of private equity investments will struggle to provide reporting and disclosure to clients. Turning to your administrator may be an option, but you cannot outsource the liability of incorrect data; in addition, the fund admin is overwhelmed. Scaling out manual resources internally is also not an option as no matter how many resources you bring to bear, automation is critical to ensuring data quality. Suffice to say, Excel is insufficient for this process.

HFM: With side pockets specifically, what trends are you seeing? And why are they challenging for accounts?

Ted Ryan: Accounting issues are exacerbated when it comes to side pockets. They are nothing new, yet the use of side pockets is expanding dramatically to the chagrin of fund administrators that have to manage these complex accounts, which often include all manner of illiquid assets. As we lead within our example, a hedge fund could have tens of thousands of capital entries per month with the number of ledger entries increasing exponentially each month.

Some Hedge Funds have even gone to the point of using two fund administrators; one to provide the raw financials and the second serves as reconciliation against the first. There has to be a better way!

Figure 1 - RyanEyes Streamlines and Automates the Side Pocket Entries and Calculations
Figure 1 – RyanEyes Streamlines and Automates the Side Pocket Entries and Calculations

Looking beyond sheer scale for a moment, the challenge with side pocket accounting is it is, in many ways, a hybrid between a “mini-fund” and an investment. The assets of a side pocket account are recorded on a fund’s books, but they are tracked separately. Their accounting and valuation calculations are shared with investors but are often complicated and valuations may change dramatically depending on the asset and market conditions.

With some of the complexity leverage arrangements, and now additional reporting requirements, we are seeing side pocket fee allocation, investor performance tracking and liquidity management become critical issues. It’s now not enough to simply report value, fees, and other traditional aspects.

HFM: How do accounting practices have to be different for side pockets? To what extent do private equity assets in side pockets complicate matters?

Ted Ryan: One of the proposed SEC requirements, for example, is that fees incurred by side pockets need to be strictly tracked so one side pocket is not paying another’s fees. These are typically issues that you would see in a multi-strategy hedge fund. In effect, each side pocket is its own strategy but instead of just for internal reporting, the “deal” is reported to investors. If there is any “bleed” over from one deal to another, the SEC could penalize the fund.

With regulators focusing on transparency and risk, side pockets will inevitably attract greater attention. We only have to look to 2008 to see their use became a flashpoint during the financial crisis, when some managers inundated with withdrawal requests relied on provisions in their fund documents to segregate assets over their clients’ objections. For example, in a Wall Street Journal article in 2017 they discuss that after wave of withdrawal requests from its flagship fund, Pine River Capital asked investors to vote on whether it could segregate about $90m in illiquid assets.

And remember, expense tracking is highly dependent on individual analysts being diligent with the expenses and allocating them correctly. The majority of the expenses could be shared across a number of side pockets; valuation and legal documents may not have invoicing that reflects this reality

HFM: How has RyanEyes tackled the side pocket accounting dilemma facing funds?

Ted Ryan: Automation, automation, automation. Whether automating the collection and allocation of expenses to side pockets or the automation of complex fee calculations, RyanEyes software seeks to streamline and remove the obstacles to ensuring accurate and timely data. In addition, RyanEyes integrates with a number of fund admin data interfaces to confirm that the fund administrator is correct. Further, RyanEyes has the ability to automate the calculations and the tracking of each side pocket and the loans against the asset. Finally, the software tracks custom fee structures and liquidity terms in each side pocket account.

In almost every case, the transition from spreadsheets to RyanEyes software saved the firm’s fund administrators three to four days of manually extracting and reconciling each side pocket’s data and calculations. In addition, new private equity investments were handled with RyanEyes automating the entering and processing of additional side pocket entries saving an additional several days.

HFM: What are the benefits of greater disclosure and more accurate/succinct accounting of side pockets?

Ted Ryan: Side pockets should not have to get in the way of how a hedge fund generates returns for its investors. Unfortunately, the accounting difficulties surrounding side pockets mean their use of illiquid assets can severely hamper an overall fund’s day-to-day operations. Hedge funds and private equity funds have been investing in an increasing number of illiquid investments for a variety of reasons and using the assets as a means to borrow additional funds. Essentially, side pockets are the exceptions to the commingling process that funds traditionally follow. However, this presents a nightmare for accounting and administration teams that must value the illiquid asset, track its value for the fund’s monthly NAV and manage the loan against the asset.

HFM: How can this benefit both the fund managers and their end clients?

Ted Ryan: Being able to gain stronger oversight over side pockets and deliver accurate and insightful accounts for them significantly boosts the transparency and disclosure of an overall fund. This extends beyond regulatory compliance and operational advantages.

Greater disclosure can be used as a marketing tool by managers. What was once typically accepted as opaque by investors will now become demanded by investors. The savvy manager will use these new rules to market more detailed data. The manager that simply “stands still,” and assumes nothing can be done to manage the increasing complexity of side pockets will be left behind.

Conclusion

As we suggested in both the previous side pocket blog post and Ted reiterated in this HFM Week interview, side pockets are often managed manually through spreadsheets and updated by creating new sheets and cutting and pasting existing formulas from the previous month’s sheet. It is a brutally painstaking, time-consuming task that can often absorb up to 3 or 4 days of fund administrator’s time.

RyanEyes software has the ability to automate the calculations and the tracking of each side pocket and the loans against the asset. Further, the solution tracks custom fee structures and liquidity terms in each side pocket account. In addition, for monthly or periodic valuation, RyanEyes will process the sidepockets with the so that they are properly tracked and reported.

As the number of side pockets grows RyanEyes has the ability to handle not only the automation of entries and calculations, but also the impact they have on NAV, the General Ledger, and Investor Returns.

 

To Learn More About Handling the Side Pocket Accounting Issues for Your Organization – Contact Us, We Are Happy to Help – 1 (833) 352-7111.

You Can Also Fill Out Our Contact Us Form Here to Talk with a RyanEyes Consultant – https://www.RyanEyes.com/contact-us/