What Are Side Pockets?
Side pockets are a mechanism used by hedge funds and other investment vehicles to separate certain illiquid assets from the rest of the fund's portfolio. These illiquid assets include private equity investments, distressed securities, or other investments that are not easily traded in the market. By creating side pockets, fund managers can maintain the fund's overall liquidity while preventing the illiquid assets from negatively impacting the fund or investors’ ability to redeem from the fund.
Side pockets have a long history in the world of hedge funds and private equity. During the 2008 financial crisis, many hedge funds found themselves unable to meet investor redemption requests due to the illiquidity of their investments. The use of side pockets became more common during this period to prevent a complete freeze on redemptions and to protect the interests of existing investors.
Side pockets have also been used in private equity funds, where investments in unlisted companies may have a longer investment horizon. These funds use side pockets to separate illiquid investments from the rest of the portfolio and offer investors the option to exit the fund while preserving the value of the illiquid assets.
Do They Still Exist?
Side pockets are still a financial instrument used in specific circumstances by both hedge funds and private equity funds. However, in recent years, the relevance and prevalence of side pockets have diminished for several reasons:
1. Regulatory Changes: The 2008 financial crisis prompted regulatory agencies to scrutinize the use of side pockets. As a result, regulations surrounding side pockets became stricter in some jurisdictions. For example, the Alternative Investment Fund Managers Directive (AIFMD) in Europe imposes limitations on the use of side pockets by hedge funds and private equity firms.
2. Shift Towards Liquidity: Investors have become more cautious about investing in funds that employ side pockets, as they can complicate the redemption process. Many investors prefer funds that offer daily liquidity or have shorter notice periods for redemptions.
3. Improved Risk Management: Fund managers have improved their risk management practices, aiming to avoid situations that necessitate side pockets. They use more sophisticated techniques to assess and manage the liquidity of their portfolios.
4. Increased Transparency: In response to investor demand for greater transparency, many fund managers now provide more detailed information about the composition of their portfolios, including illiquid investments. This transparency reduces the need for side pockets.
Once a prevalent tool for fund managers to handle illiquid assets, side pockets have seen a waning in their usage and importance over time. In the ever-changing financial landscape, side pockets have lost the prominence they once held, making way for the adoption of new tools and approaches.