Side pocket accounts have a long history in the hedge fund industry, yet the use of side pockets is expanding dramatically to the chagrin of fund administrators who have to manage the complex accounts. Briefly, a side pocket is a type of account utilized in hedge funds to segregate riskier or illiquid assets from more liquid investments like equities and bonds.

The illiquid assets in these side pocket accounts include investments such as real estate, antiques, over-the-counter (OTC) stocks, stocks with extremely low trading volume, stocks delisted from exchanges, and private equity investments.

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. Recently, funds are not only increasingly adding side pockets to the fund, but they are also taking out loans against the assets to increase leverage, thus creating a massive challenge for accounting and fund administrators.

Side-Pockets Have a Controversial History

As hedge funds turn to longer-term stock and debt investments, some are placing as much as 25% of their investments in these side accounts. An accurate value for these investments sometimes can be derived only when they are disposed of, so hedge funds often are slower to put up-to-date valuations on the accounts.

Regulators say side pockets are appropriate for investments that are difficult to value or are illiquid, that is, hard to trade, noting that if a fund was forced to place an inappropriate value on these investments, it could penalize a fund’s investors.

Even back in 2006, then SEC Commissioner Roel Campos suggested “Hedge funds may hide poor-performing assets in side-pocket accounts to exclude such assets from the fund’s valuation for purposes of calculating performance fees.”

For example, various hedge funds have gained this year, with an example fund that we found rising about 7% through May. In this case, investors will pay a “performance” fee, paid on a quarterly basis, that amounts to a percentage of these gains.

However, some of the firm’s side-pocket investments dropped about 6% through the end of April — the most recent date that investors have been informed of the performance. If these investments hadn’t been placed in the side investments, their losses would have cut the gains on the fund to about 5%, reducing the fund’s performance fees and hurting the track record used to attract new investors.

Side pockets became a flashpoint during the financial crisis when some hedge-fund managers inundated with withdrawal requests relied on provisions in their fund documents to segregate assets over their clients’ objections.

In addition, side pockets 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 way back 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 $90 million in illiquid assets.

Clients said the request from the $8.5 billion firm was a response to a move by investors to pull more money than Pine River expected from its $1 billion flagship fund, which has significantly lagged behind the S&P 500 the past two years.

As a note, we wrote three blog posts on the Archegos disaster, the GameStop short squeeze, and Infinity Q Swap Pricing debacle which provide interesting stories of funds that cost their clients Millions; not through the use of side pockets, but by not assessing risk appropriately. Side pockets are often placed in separate accounts and the risk of these illiquid investments may not be evaluated with the assets in the rest of the fund and thus, increase the risk of an investment in the overall fund.

The Explosion in the Use of Side Pockets

A leading Hedge Fund has hundreds of investors with approximately 20 side pockets 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.

Side pockets were often managed manually through spreadsheets and updated by creating new sheets and cutting and pasting existing formulas from the previous month’s sheet. It was a painstaking, time-consuming task that in one account absorbed two high-level employees for three days. However, now, with thousands of additional entries and subsequent calculations spreadsheets have grown to over 150MB in size, become corrupted and calculations have copied incorrectly or changed over time making the valuations incorrect.

When a fund manager decides to create a side pocket existing shareholders are allocated shares in the new side pocket account on a pro-rated basis. These shares cannot be redeemed until either the fund manager realizes a portion or all of the side pocket investment creating additional challenges for accounting and fund administrators.

Side pockets were often managed manually through spreadsheets and updated by creating new sheets and cutting and pasting existing formulas from the previous month’s sheet. It was a painstaking, time-consuming task that in one account absorbed two high-level employees for three days

The Accounting for Side Pockets in a Hedge Fund

Typically, all of the assets a fund owns is commingled into one portfolio and investors simply own a percentage interest in the whole fund. While management fees and incentive structures may vary participant-by-participant in a hedge fund, the general fund accounting is simplified by everything else being commingled.

Side pockets are the exceptions to the commingling process. When securities are illiquid or hard to value and constitute some significant part of a fund’s assets side pockets are created. 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.

This has become a nightmare for accounting and fund administrator teams to must value the illiquid asset, track its value for the fund’s monthly NAV and manage the loan against the asset.

How to Manage, Track and Report the Use and Value of Side Pockets

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

In this case, the transition from spreadsheets to RyanEyes software saved the firm’s fund administrators 3-4 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 1-2 days.

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

Conclusion

To wrap up this blog post about Side Pockets we wanted to leave you a list of issues that should be evaluated as you document, manage and account for Side Pockets in your fund. Initially, we’ll start with the rationale for creating a side-pocket; that is the asset that is being evaluated and why there is a higher level of valuation uncertainty or liquidity issues associated with that asset. The following are the other items that should be considered and documented when creating a Side Pocket:

• Timing of the side-pocket – is this to be created immediately after the event occurs or when there is capital activity and the rationale for this choice.
• Size and Structure of the side-pocket – This should include details of any proposed transactions between the main fund and the side-pocket. Where the side-pocket is not a separate legal entity, details of the allocation of assets, liabilities, trapped collateral, and income should be documented.
• Fees – That is if separate fees will be charged on the side-pocket and when they will be created and documented (where side-pockets have occurred before are these fees in line with prior side-pockets and if not, why).
• Exit criteria – That is when will the side pocket assets be available for release back to investors or into the main fund (as discussed above this may not always be possible at the creation of the side-pocket).

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