While hedge fund side pockets are typically used by hedge fund managers to manage liquidity and reduce risks around sudden redemptions, managers are increasingly viewing side pockets as a path to opportunities outside of a fund’s core strategy or mandate, as they can be used in pursuit of asset classes like private equity and real estate, derivatives or cryptocurrencies.
Having moved beyond the initial suspicious attitude in the wake of the 2008 financial crisis, where regulators were concerned about the potential for abuse, side pockets have now gained respect as a tool to benefit investors. Originally intended to be segregated illiquid investments from liquid and traditional investments in a portfolio, side pockets can also include investments like new acquisitions or existing holdings that are reclassified as illiquid. When a side pocket is created, investors in the fund receive pro-rated interests, which are locked in until the underlying assets are liquidated or returned to the main portfolio.
However, while side pockets protect funds in many ways, they also present operational, accounting and reporting challenges that fund managers must be aware of.
- Segregated and aggregated accounting—Side pockets must be tracked and valued on a stand-alone basis, but the accounting for the full fund entity must include the side pocket.
- Investor accounting and reporting—Investors need to see how their assets are performing, whether they are invested in only the general fund or side pockets as well.
- Performance and management fee calculations—Performance fees are not usually charged until there is a realization event, adding a layer of complexity to fee disclosures.
Many fund managers choose to address these challenges through outsourcing to a technology and operational service provider with the infrastructure and expertise to support side pocket investments. To learn more about the operational complexities of side pockets, as well as how outsourcing with a provider like SS&C can help, download our Hedge Funds: Accounting and Reporting for Side Pockets whitepaper.
