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A side pocket is a special designation used for illiquid assets in a hedge fund to separate them from other investments in the fund. The fund managers can place assets in a side pocket at any time. Members of the fund are given special shares reflecting their interest in these investments. People who join the fund after the manager creates the side pocket will not be entitled to a share in the proceeds when these assets are liquidated. Financial regulators monitor the progress of separating investments in this way for any signs of suspicious behavior.
There are a number of reasons fund managers create side pockets. When a fund contains a mixture of liquid and illiquid investments and a member of the fund decides to terminate her position with the fund, the manager must pay out, but the value determination can be complicated by the illiquid assets. It's possible the person leaving the fund may not receive a fair value for her shares, and the manager will also need to liquidate more assets to cover the value of the illiquid assets. If the value estimation is wrong, the person may be over or underpaid. In cases where people pull out and get more money than they deserve, the remaining members of the fund pay the price.
By separating out hard to value and liquidate assets, the fund manager can protect the interests of all members of the fund. The value of liquid shares in the fund can be disbursed when someone leaves, with a promise of future payment when the side pocket is liquidated. This allows the manager to retain those assets as long as necessary to get the best value for them.
This practice does require more bookkeeping. The fund manager needs to keep track of who owns shares in the side pocket and who does not. As people join the fund, they have shares in the main part of the fund but not any side pockets, and their membership must also be tracked accordingly.
One concern with the practice of creating side pockets to isolate investments is abuse of this practice to give special perks to certain members of the fund, or to skew the valuation of the fund. Side pocket investments are valued separately than the main fund and the fund manager could isolate troubled assets to make the fund appear healthier than it is. Fund managers can be fined for failing to use this investment tool appropriately, and particularly prominent cases will usually be a topic of discussion in financial publications, alerting investors to mismanagement on the part of a particular fund.
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