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!