Years ago, when an asset held by a fund suddenly became illiquid, there were not many good options available. Whether the issue was a market crisis, a trading suspension, sanctions, a delisting, or simply the absence of willing buyers, the consequences were often felt across the entire portfolio. Not every investment can be traded with the click of a button. This could create a difficult situation for both investors looking to redeem and those choosing to remain invested.
Following the financial crisis of 2008, side pockets became a widely adopted solution to this problem. By separating certain illiquid or hard-to-value assets from the rest of the portfolio, fund operators were able to protect both redeeming and remaining investors while allowing the fund’s liquid assets to continue operating as normal.
At first, side pockets were largely seen as a defensive tool, something to be used when markets became disrupted or when a particular investment could no longer be fairly valued or readily sold. Their purpose was simple: protect investors and preserve fairness within the fund.
At the same time, however, one of the biggest challenges in the open-ended fund industry has always been balancing liquidity with opportunity.
On the one hand, investors value the flexibility to subscribe to and redeem their investments at regular intervals. On the other hand, some of the most attractive investment opportunities are not always easy to sell. Private investments, distressed debt, litigation claims, pre-IPO shares and other special situations can offer compelling returns, but they often come with one catch: they may be difficult to value or impossible to trade at a moment’s notice.
Over time, fund operators began to realise that the same mechanism originally designed to deal with problematic assets could also be used to accommodate investment opportunities that naturally required a longer time horizon. What started as a tool for dealing with exceptional circumstances gradually evolved into a flexible structuring feature.
The original side pocket
Imagine a fund holds ten investments and one of them suddenly becomes impossible to sell. The rest of the portfolio may be trading normally, but that single investment now presents a problem. If investors are allowed to redeem based on a valuation that may no longer reflect reality, someone is likely to benefit at the expense of someone else. Investors who redeem early may receive more than their fair share, while those who remain invested could be left holding the risk.
Side pockets were developed to solve that fairness problem.
While side pockets existed before the global financial crisis, the events of 2008 highlighted just how important they could be. Assets that had previously appeared liquid suddenly became difficult to trade, valuations became uncertain, and fund operators were forced to navigate unprecedented market conditions. In many cases, side pockets provided a practical way to separate troubled assets from the rest of the portfolio, allowing the fund’s liquid investments to continue operating normally.
Over the years, the list of situations giving rise to side pockets has continued to grow. Distressed assets, suspended securities, delistings, sanctions, litigation claims and private investments have all found their way into side pockets at one time or another. Regardless of the circumstances, the underlying issue is usually the same: the fund owns an asset that cannot easily be sold or fairly valued, at least for a period of time.
In each of these situations, fund operators face a difficult choice. They can continue valuing the asset and risk treating investors unfairly, or they can suspend the calculation of the fund’s net asset value and restrict dealing in the fund.
While suspending a fund may sometimes be necessary, it is rarely a desirable outcome. Investors value certainty, transparency and access to their capital. Even when a suspension is justified, it can raise investor concerns and undermine confidence in the fund long after the underlying issue has been resolved.
Side pockets offered a more practical alternative. Rather than bringing the entire fund to a standstill because of a single problematic investment, they allowed fund operators to isolate the issue, protect investors and continue managing the remainder of the portfolio as normal.
How a side pocket actually works
The concept is much simpler than it may first appear.
Imagine a fund with a total net asset value of US$100 million. One investment representing US$10 million suddenly becomes illiquid following a trading suspension. While the rest of the portfolio continues to trade normally, the fund can no longer confidently determine when, or at what price, that particular investment can be sold.
Rather than forcing all investors to remain invested or relying on an uncertain valuation, the fund may place that investment in a side pocket.
When this happens, the affected investment is effectively separated from the fund’s liquid portfolio. Investors who are invested in the fund at the time the side pocket is created receive side pocket shares representing their proportionate interest in that asset. The remaining US$90 million portfolio continues to operate normally, allowing subscriptions and redemptions to occur in the ordinary course.
This distinction is important. Only the investors who invested in the fund when the side pocket was created participate in the side-pocketed investment. New investors entering the fund after that date will participate only in the liquid portfolio and will not share in any future gains or losses associated with the side pocket. Similarly, investors who subsequently redeem their ordinary shares will generally continue to hold their side pocket shares until the underlying investment is sold or otherwise realised.
If the side-pocketed investment is eventually sold for US$12 million, the additional value belongs to the investors who held the side-pocket shares. Likewise, if the investment ultimately realises less than its original value, the loss is borne by those same investors.
In this way, side pockets help ensure that the investors who were exposed to the investment when the issue arose are the same investors who bear the eventual outcome, whether positive or negative.
The evolution of side pockets
For many years, side pockets were viewed as a solution to a problem. They were created to deal with assets that had become illiquid, difficult to value or otherwise problematic. In other words, they were largely reactive.
Over time, however, fund operators began to recognise that the same mechanism could be used proactively. Rather than waiting for an investment to become illiquid, side pockets could be incorporated into a fund’s design from the outset, allowing managers to access a broader range of investment opportunities while maintaining liquidity for the remainder of the portfolio.
This opened the door to investments that many open-ended funds would traditionally have avoided. Private credit, pre-IPO investments, distressed claims, litigation assets and private restructurings could now sit alongside more liquid investments within the same structure.
The result has been the rise of what are commonly referred to as hybrid funds. Rather than forcing managers to choose between liquidity and opportunity, these structures allow both to coexist within the same vehicle. Investors can continue to benefit from a liquid portfolio while participating in selected investments that may require a longer investment horizon.
We explored this trend in greater detail in our article The Rise of Hybrid Funds, but it is difficult to discuss the growth of hybrid funds without recognising the important role side pockets have played in making them possible.
Getting the best of both worlds
While side pockets remain an important safeguard during periods of uncertainty, their growing use in hybrid fund structures demonstrates how the industry has adapted to investors’ desire for both liquidity and access to a wider range of investment opportunities.
In many ways, side pockets have evolved from an emergency measure into a practical way of getting the best of both worlds.
Whether you are launching a traditional open-ended fund, exploring a hybrid fund strategy, or simply considering how designated investments may fit within your structure, careful planning at the outset can make a significant difference.
Shelley Do Vale is the founder and managing partner of Vale Group.
