Side Pockets

The term "side pocket" refers to a portion of the hedge fund that is segregated from the remainder of the assets for certain illiquid investments. These illiquid investments are hard to value, as much of the investments are class 3 assets, which do not even have a comparable assets class that are priced by market forces. Hedge Funds uses their own internal models to value them (which can be biased)! The profits and losses derived from a side pocket investment are allocated solely to those investors that are in the fund at the time such investment is made. The capital related to such investment is not available for withdrawal until such investments are realized or otherwise become marketable securities. Typically about 10 to 15 percent of a fund may be reserved for side-pocket allocation, although there have been instances of larger side-pocket pools.

On the larger scale, there is potential for excessive leverage. For example- a subsidiary of Hedge Fund (say in a business of distressed lending) may keep on transferring its riskier positions into side pockets to free up and raise more capital from its parent Hedge Fund for fresh investments. This is called leverage. Though organizations are more responsible today & keep a check on their leverage strategy, but one can never know when LCTM part-2 happens!!!

Excessive concentration of positions, the dependence of valuations upon complex proprietary models, and high leverage are some issues that raises concerns over side-pockets. Hedge funds propogate that side pockets are necessary to bundle & classify a similar type of investments because different investors have a different investment horizon & objectives. Whatever be the objective, the system should be made more transparent to the market & investors. This way the fund managers are more responsible & these issues will be addressed batter.

On a different note, I personally feel that Hedge funds should more concentrate on improving the performance of their investments than being busy with transferring & bundling investments into side pockets. There are numerous compliance, transfer rules, auditors & back office stuff that just keep the organization busy, forgetting the main objective - returns! Thats the difference between a Leveraged Buyout & a Hedge Fund - Once the Leveraged Buyout firms buys a company, they work closely with them on its turnaround strategy, unlike Hedge Funds that investes & sleep!

Independent Portfolio Valuation of Hedge Funds & PE Assets on a Rise....

Independent Portfolio Valuation: The Independent Portfolio valuation service is a relatively new business area where companies have their illiquid assets valued by some third-party evaluator. This was born from the need of financial institutions to have transparency in their asset valuations as well as a slew of regulatory moves of which FAS 157 has been the latest. Also owing to the present doldrums in the market, independent valuations serve to reassure institutional investors as well.

Growth Drivers:
· Regulatory Changes Driving Demand (FAS 157): Demand for independent portfolio valuation services continues to be positively affected by increased regulatory scrutiny of corporations, a shift toward fair value accounting principles, increased awareness of and sensitivity to conflicts of interest and the globalization of corporations. In the US, Financial Standards Accounting Board (FASB) Statements Nos. 141 and 142, 123(R), 157, and 159 are a few examples of statements that require valuation expertise. Effective November 15, 2007, FASB mandates that assets be measured at "fair value", described as "the price that would be received if those assets are sold today". Here the companies need to determine the fair value of their hard-to-value securities (level 3 assets), which do not even have a market trading comparable. Valuing such investment has always been difficult, and with the introduction of FAS 157, these level 3 assets have to be valued at today’s prices. This requires specialized valuation advisory services, so that the valuations numbers get the clearance from auditors.

Companies in the financial services space such as investment banks, hedge funds, private equity funds, etc., will be the most affected as they hold significant amount of Level 3 assets. FAS 157, coupled with the credit turmoil, should have a positive impact on the demand for the independent evaluations. With the introduction of FAS 157, PE and hedge funds can provide comfort to their investors, auditors, and fund managers by seeking independent estimates of the fair values for Level 3 assets.

· Alternative Assets: Alternative asset classes (like investments in arts) continue to flourish as many hedge funds are setting up specialized funds focusing on the same. These asset classes are difficult to value sometimes as they contain illiquid assets; which has led to firms and investors requesting independent valuation on their portfolio.

· Sarbanes-Oxley - Limiting Auditors on providing certain non-audit services: Provisions of the Sarbanes-Oxley Act of 2002 limit an accounting firm’s ability to provide certain non-audit services (including valuation or appraisal services, fairness opinions) to its audit clients. These restrictions, together with the perceived conflicts of interest when auditors provide valuation services to their audit clients, provide independent portfolio valuation firms with a competitive advantage over public accounting firms. This has led to evolution of new financial service class called “Portfolio Valuation Firms”.