Side Pockets and Illiquid Asset Segregation
A fund structure that walls off hard-to-value or hard-to-sell holdings into a separate account, so redeeming investors aren't forced to sell them at a fire-sale price and remaining investors aren't diluted.
A hedge fund that holds a mix of liquid, exchange-traded positions and a few illiquid stakes — a private placement, a distressed bond with no active market, a stake in a company that's frozen during a restructuring — faces a problem when investors want to redeem: selling the illiquid piece quickly to raise cash could mean selling at a steep discount, hurting the value everyone else in the fund holds. A side pocket solves this by carving the illiquid holding out of the main fund into its own separate account, with its own accounting.
Investors who were in the fund when the side pocket was created keep their proportional interest in it, but that interest isn't included in the regular net asset value used for day-to-day subscriptions and redemptions, and it typically can't be redeemed until the illiquid asset itself is eventually sold or otherwise resolved. New investors coming into the fund after the side pocket is created get no claim on it at all. This keeps ordinary redemptions from being forced through a fire sale of the illiquid asset, and keeps new money from free-riding on (or being penalized by) a stake it never had exposure to.
The trade-off is reduced transparency and liquidity for the investors who do hold a side-pocketed interest — their capital can be effectively locked up for years with no clear timeline, which is why side pockets are a frequent source of investor complaints and are used more sparingly since the 2008 crisis pushed many funds toward simpler, fully liquid structures.
A side pocket separates an illiquid holding into its own account outside the fund's regular net asset value, protecting redeeming investors from a fire sale and new investors from unrelated exposure — at the cost of locking up the affected capital for existing investors with no fixed exit date.
Further reading
- Lhabitant, Hedge Funds: Quantitative Insights, ch. 2