Hot pocket

The demarcation between private equity and hedge funds has become more and more difficult to pinpoint, as their strides toward convergence continue apace. As hedge funds seek to boost alpha, crossing over to investing in illiquid assets – traditionally the turf of private equity – has become a more significant part of these funds' strategies.

Not only are more hedge funds dipping their toes in illiquid assets, hedge funds with existing private equity-like programs are allocating more of their portfolio in that direction. Whereas in the past, the norm would have been a 10 percent cap on the portion of a portfolio than can be held in side pockets – vehicles that are used to ?hold? illiquid assets, market observers now see increasing numbers of hedge funds with 20 percent and higher allocations.

?The use of side pockets have become more popular because it allows large [hedge] funds to take on attributes of what looks like a private equity fund,? says Richard Finlay, a partner in the Cayman office of law firm Conyers Dill & Pearman.

Side pocket applications
For those hedge fund managers pursuing strategies that involve holding onto illiquid assets, the main appeal of the side pocket is that it spares the manager the trouble of having to put a value on the illiquid asset. Hedge funds are marked to market, which in theory allows investors to enter into and exit out of the fund (subject to a lock-up period) based on the fund's net asset value. The management and performance fees charged by the fund managers are also calculated based on NAV.

Therefore, holding assets whose value may be unknown due to their illiquid nature can cause valuation problems for hedge fund managers – unless they are able to segregate these investments into side pockets.

The decision to use side pockets can take place at a couple of points in the life of a hedge fund. One is at the launch of a new fund, at which point the fund manager states that it intends to use side pockets for specific illiquid investments. ?There, the investment manager should be better able to describe what he's putting in the side pocket and what percent of the portfolio will be placed in side pockets,? says Finlay.

The other point is during the life of the fund, when a side pocket is used as what Finlay describes as a ?parachute.? This typically happens when an investment manager may not have intentionally acquired illiquid investments; however, for some reason, an investment in the portfolio becomes illiquid due to unforeseen causes. ?A side pocket in that situation is a parachute that allows the investment manager to deal with the illiquid investment and still maintain the integrity of the fund,? says Finlay, adding that in this type of situation, it is more difficult to set objective rules for allocating investments using side pockets, given the unanticipated nature of the precipitating events.

Terms of note
The way private equity and hedge funds charge fees for managing and growing these assets differs, as do the terms guiding the way these two types of managers can invest. ?You don't yet see the full collection of private equity fund negotiated terms in a hedge fund, even if it has a good sized side pocket allocation,? notes Stephanie Breslow, a partner in the New York office of law firm Schulte Roth & Zabel.

However, hedge fund documents typically do include some basic terms regarding side pocket investments:

Usage. In terms of setting up the side pockets, a fund manager's ability to do so is built into the fund documents rather than turning to investors for the thumbs up before an asset is placed into a side pocket. Generally, the investment manager is given some degree of discretion as to what and when to side pocket an asset, says Finlay. He adds: ?Because side pockets are so fluid in nature, it's left to the investment manager to react.?

Given the level of discretion and flexibility bestowed upon the fund manager, Finlay emphasizes that disclosure is important and is typically addressed in the fund documents. For instance, if the investment manager has complete discretion over when and how much of the portfolio to put into side pockets, then that is something that should be disclosed to the investors. Although oftentimes difficult to accomplish in practice, it is preferable to disclose the objective parameters the investment manager will consider for putting an asset in a side pocket, adds Finlay.

In addition to disclosure, ?You might put in some sort of mechanism where the investment manager's decision as to what was put into a side pocket was monitored,? says Finlay. ?That may be an appropriate function of the directors of the fund vehicle or some committee formed for that purpose.?

Recently, side pockets have come under greater scrutiny by regulators and the media, in part because some investors have accused hedge fund managers of using of these vehicles to hide failing assets. Would a good solution be to require the fund manager to create a side pocket at the moment it buys the asset? Not necessarily, says Breslow, describing a situation in which a hedge fund invests in a stock of a company, which later collapses. ?At the time that the stock was bought, there was no reason to think about putting it into a side pocket, but when it became distressed, it was a very volatile security, and it was more fair to move it into a side pocket than to come up with very speculative values,? explains Breslow.

Caps. While there is no hard and fast rule on the size of the ?side-pocketed? portion of the portfolio, the market standard is to hold no more than 30 to 40 percent of the overall portfolio in side pockets, says Finlay.

Trigger event. ?If someone's buying into a fund which has, by definition, illiquid investments and, given that investors are generally interested in liquidity in some form at some time, there has to be a clear understanding of what the trigger event is for that investment to be realized,? says Finlay. ?Otherwise, the investor has no idea what he's buying into.?

What comprises a trigger event depends, inexorably, on the investment, says Finlay. ?If an investment is looking for a listing, then that is the logical trigger event. Or, it could be something a little more complex tied to valuation or disposition.?

?The disclosure should contain a clear description of the trigger event,? says Finlay. ?It may be necessary to give the fund manager discretion, but this can be problematic since there may be different expectations of what the trigger event should be.? Finlay adds that in this case, there is a ?logical distinction? between the new fund scenario and the ?parachute? usage; in the latter, figuring out what the trigger event becomes more difficult to answer.

Fees. The typical fees that fund managers charge on side pocketed assets are the 1 percent to 2 percent management fee and 20 percent performance fee (paid annually and subject to a high water mark but not to clawback) standard for the overall hedge funds.

?It's fair to say that market practice is changing a bit in this area,? notes Finlay. ?At one point, it was generally regarded that it may not be appropriate to charge fees for side pocket investments – both because they were illiquid and they were difficult to value. It's now becoming more prevalent practice that fees are paid.?

Fees from management of side pocket assets are typically paid out in one of two ways, depending on whether the investor has sold its assets in the general fund. For an investor that has capital committed to both the general portfolio and the side pockets, the fee can be calculated and paid out of the general portfolio assets. Or, if the investor is no longer invested in the general portfolio, the fees could be accrued against the side pocket and taken upon realization.

Private equity funds often contain more stringent provisions than hedge funds about issues such as maximum holding periods for investments, position size, leverage caps, exclusive allocation of deal opportunities, time commitments of the principals and the maximum capital a fund can accept. However, when hedge fund side pockets become so significant that the fund is viewed as a hybrid, private-equity style protections may be included, notes Breslow.

While the usage of side pockets is far from new, these vehicles have been increasing in popularity in recent years. For private equity firms that may encounter hedge funds as potential competitors or partners for deals, an understanding of these funds' structure – and their limitations – can be useful.