Monday, July 30, 2012

Hedge Fund "Side Pockets" Explained

By Tim Husson, PhD

Hedge funds can be extremely complicated investments, and one of the features that contributes to their lack of transparency is their so called 'side pocket' accounts.  Side pockets have drawn scrutiny from the SEC and have been the subject of high profile investigations (see also) due to their potential for abuse from hedge fund managers eager to hide losses from investors.

Side pockets are essentially separate accounts that a hedge fund may use to separate illiquid or thinly traded assets from the primary fund itself.  Side pockets are typically structured as an independent private equity fund, and are typically not available to new investors in the primary hedge fund.

Side pockets were originally designed to protect investors.  Hedge fund managers have an inventive to record hard-to-value assets at inflated prices in order to maximize apparent returns and thus their performance fees.  Keeping illiquid securities in a separate account, and therefore independent of the manager's performance fee, was thought to reduce that incentive.

However, several funds have been accused of using their side pocket accounts to hide losses from investors during the financial crisis.  In addition, side pocket investments may be particularly difficult to withdraw from, since many include provisions that liquidation may only take place at the manager's discretion and not in response to investor withdrawal requests.  According to the Wall Street Journal, hedge funds have since changed the terms of their fund agreements to allow more extensive use of side pockets to freeze holdings, suggesting that the problems surrounding these investments may only increase.

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