Alternative Investment

Exploring the Benefits of Side Pockets in Funds

Side pockets have long been a valuable tool in fund management, particularly for hedge funds, private equity, venture capital, and even cryptocurrency funds. By segregating illiquid or challenging-to-value investments from the main portfolio, side pockets provide distinct advantages for both investors and fund managers.

This blog post explores the benefits of side pockets, their role in improving operational efficiency, and how they enhance both investment management and client experience.

What Are Side Pockets?

Side pockets are special allocations within a broader fund that are used to house illiquid or hard-to-value assets. These assets are separated from the main portfolio, ensuring that both their performance and valuation are managed independently. Side pockets are particularly common in funds dealing with investments such as:

• Private equity deals
• Distressed assets
• Cryptocurrencies
• Venture capital commitments

With side pockets, fund managers gain greater flexibility to manage long-term or less-liquid assets without impacting the liquidity and valuation of the main fund.

Benefits of Side Pockets for Investors

Side pockets aren’t just a tool for fund managers—they also offer several important advantages for investors.

Enhanced Transparency

Investors gain clearer insights into the fund’s structure and holdings:

• Segregation of Illiquid Assets: Illiquid investments are housed separately, allowing investors to better understand the risks and liquidity of their investment.
• Improved Clarity: Transparency regarding which assets are liquid versus illiquid reduces uncertainty, making it easier for investors to assess the risk-return profile of their holdings.

Reduced Impact of Illiquid Assets

By isolating illiquid investments within side pockets, funds protect their main portfolios against potential disturbances:

• Stable NAV: The net asset value (NAV) of the main fund reflects only the liquid assets, ensuring that redemption requests or market fluctuations don’t distort the valuation.
• Minimized Redemption Impact: Side pockets prevent illiquid investments from being unfairly impacted by redemptions in the liquid portion of the fund.

Fair Valuation During Redemptions

Illiquid investments can often pose challenges during redemption periods, but side pockets prevent forced sales:

• Avoiding Fire Sales: By housing illiquid assets separately, funds avoid selling these investments at unfavorable prices. This preserves their inherent value for long-term investors.
• Equitable Treatment: Investors remaining in the fund are not penalized by the need to meet redemption requests, ensuring fairness across the investor base.

Targeted Performance Tracking

Side pockets allow funds to report performance metrics separately, giving investors a clear picture of their returns:

• Detailed Reporting: Investors gain the ability to track the performance of illiquid investments independently from the broader portfolio.
• Assessment of Strategy: This separation also provides insights into how different investment strategies contribute to the fund’s overall success.

Strategic Tax Advantages

Side pockets can streamline taxable events:

• Targeted Allocations: Gains or losses from illiquid investments can be allocated to specific investors within the side pocket. This avoids unnecessary tax consequences for other partners in the main fund.

Benefits of Side Pockets for Fund Managers

While investors benefit from transparency and stability, fund managers see operational and strategic advantages from using side pockets.

Flexibility in Investment Strategy

Side pockets empower fund managers to consider long-term, high-potential opportunities:

• Focusing on Illiquid Opportunities: Managers can confidently pursue investments requiring extended time frames, such as private equity or distressed asset transactions.
• Enhanced Portfolio Customization: They can structure investments tailored for select investors with preferences or appetites for illiquidity.

Reduced Redemption Pressure

Redemption demands are significant challenges for funds managing illiquid assets, but side pockets mitigate this pressure:

• Stability Under Redemption Requests: By segregating these investments, side pockets reduce the risk of forced asset sales to maintain liquidity.
• Improved Control: This gives fund managers more freedom to adhere to their investment strategy without being derailed by short-term liquidity needs.

Attracting and Retaining a Broader Investor Base

Flexibility in fund structure makes side-pocketed funds more appealing to diverse investors:

• Meeting Investor Needs: Some investors seek exposure to illiquid investments due to their higher-return potential. Clear separation within the fund allows investors to choose the risk and liquidity level they’re comfortable with.
• Building Confidence: Transparency and targeted management help build trust and attract long-term partners.

Enhanced Performance Management

Side pockets improve how performance is tracked and communicated:

• Clear Attribution: Managers can point to specific results from liquid vs. illiquid strategies, supporting investor communications and portfolio reviews.
• Strategic Insights: This segmentation also helps fund managers better analyze the impact of various strategies on the overall portfolio.

Workflow Improvements with Timing and Administration

While managing side pockets involves additional administrative, audit, and tax-related considerations, these expenditures often yield long-term benefits. Coupled with a clear strategy for tracking and reporting side-pocketed investments, fund managers can optimize efficiency and alleviate investor concerns regarding timing and valuation processes.

Summary

Side pockets are specialized allocations within funds that house illiquid or hard-to-value assets, providing significant advantages for both investors and fund managers. They enhance transparency for investors, reduce the impact of illiquid assets on the main fund, and offer flexibility for fund managers to pursue long-term investments.

To learn more about side pocket allocations and how Richey May can help you navigate the decisions surrounding them, reach out to Steve Vlasak, Business Development Partner, Alternative Investments Practice.