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Investors Should Beware of “Side Pockets”

Investor Services Update John P. Vail

On October 19th, the Securities and Exchange Commission charged two hedge fund managers and their investment advisory businesses with defrauding investors in the Palisades Master Fund, L.P. by, among other things, overvaluing illiquid assets that they had placed in a side pocket of the Fund.

A "side pocket" is a mechanism often used by hedge funds to keep illiquid investments separate from a fund's more liquid investments. A manager ordinarily postpones its incentive compensation with respect to a side pocket until the investment has been realized and charges a management fee on the value of the investment (which may be cost until there is a clear indication that another valuation is appropriate). In most cases, a fund investor who desires to redeem his or her invested funds in a hedge fund will not be allowed to redeem the portion of the invested funds that was allocated to a side pocket until the asset in the side pocket is liquidated and/or the adviser to the fund decides to release the asset from the side pocket.

The SEC alleges that the Palisades managers were concerned about significant losses from the Fund's investment in
World Health Alternatives, Inc., and that reporting such losses would cause Fund investors to try to cash out of the Fund. Widespread redemptions would severely damage the Fund and threaten its continued viability. According to the SEC complaint, the valuation of the World Health investment in the side pocket was inconsistent with the Fund's policy and substantially in excess of the managers' own undisclosed assessment of value. The SEC's complaint further states that the managers placed the World Health investment in a side pocket to prevent investors from redeeming the portion of their interests that were invested in World Health securities.[1]

A representative for the SEC stated, "Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. [The managers] deceived investors about the fund's performance and extracted excessive management fees based on the inflated asset values in a side pocket."[2]

Q&B Key: The SEC's focus on side pockets serves as a reminder to hedge fund investors to:

  • understand the level of discretion that their hedge fund manager has to place assets in side pockets. Most reputable managers limit their ability to invest in side pockets to a certain percentage of total assets, such as 20%.
  • consider whether a third party other than the manager will be involved in the valuation process to either make, or at least verify, the valuations given to the side pockets.
  • understand the valuation policies and procedures of the hedge fund manager.
  • request information from fund managers as to what assets are in side pockets and understand
    the reason why.

[1] See Complaint, dated October 19, 2010, in the matter of Securities and Exchange Commission v. Mannion, Jr., et al.

[2] SEC Press Release No. 2010-199, dated October 19, 2010.
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