Side Pockets Investments

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1 ALTERNATIVE INVESTMENT SOLUTIONS HEDGE FUND ELEMENTS Side Pockets Investments Side pockets are an accounting provision in fund documents which allow the fund manager to segregate an illiquid or hard-to-value security from the normal trading portfolio. The objective of side pockets is to fix ownership in certain securities to only those investors present at a certain point in time. Of particular interest to regulators is whether hedge funds using this provision have properly assigned a fair value, disclosed it properly to investors, and have determined fees from the side pocketed portion of the fund. This Element provides an overview of the issues and decisions that go along with creating a side pocket within a fund. What and Why the Side Pocket Basics Fundamental to all investment funds is the concept of participants having an undivided interest in the assets and liabilities of a fund. Everything the fund owns or owes is commingled into one portfolio and participants simply own a percentage interest in the whole. While management fees and incentive structures may vary participant-by-participant in a hedge fund, the general fund accounting is simplified by everything else being commingled. Side pockets are exceptions to the commingling process. When securities are illiquid or hard to value and constitute some significant part of a fund s assets, fund documents may provide for side pocketing the investment. This means freezing the participation in the security to those participants currently in the fund, with no participation in the side pocket from subsequent investors and full liquidation permitted only after the security is sold. A fund may side pocket a number of different securities over time, each with a different set of participating investors. Most fund documents provide for side pocketing certain investments at the fund manager s discretion. Typically this provision is used in two circumstances: 1) When the investment is less liquid than the normal portfolio, a side pocket can protect the fund from the effect of investor withdrawals that would otherwise result in increasing concentrations of the illiquid security. 2) When a fund has periodic openings which require a solid net asset value, the side pocket eliminates the valuation issue for difficult-to-value securities since new investors don t participate and withdrawals are only from the liquid portion. Side pockets can arise from an initial planned purchase of an illiquid security or the unplanned shift of status for a liquid asset to a compromised status. The latter has occurred in numerous funds-of-funds, where an underlying fund investment becomes illiquid due to events or securities held by that underlying fund. It is in this latter camp where valuation at the time of side pocket creation becomes crucial. Side pocketed assets, plus the expenses and fees that relate to both the commingled and side pocketed assets, create a number of accounting complexities that should be carefully considered. Participation Typically side pocket participation is based on either the investor s pro rata share of the entire fund or proportional to the non-side pocketed capital at the time of acquisition. Funds with more complex participation limits (such as no investors will have more than 20% of its capital side pocketed ) ideally contain specific language in their documents to make ownership and allocations absolutely [email protected] web

2 Side Pocket Investments continued clear to participants, administrators and auditors. To ensure fairness, a partnership document should carefully address the effects of additions and withdrawals near the side pocket event. Expenses and Fees While many documents are vague, the implications of allocating fees and expenses to investors is material and unbiased fairness is critical. 1) Fund-wide Expenses: Unless the documents contain specific expense allocation language, the partnership percentage of non-sidepocketed capital or total capital can be used for allocating overall expenses. In a fund wind-down when only side pockets remain or when recovery is several years out, some fund managers will set up a cash reserve for expenses and fees pertaining to the specific side pocket for things such as future K1s or legal expenses. 2) Management Fees: If management fees are charged based on side pocket capital values, the valuation of the side pocket is material to auditors and investors. Therefore valuation of the side pocket must be substantiated. 3) Hold Backs: If the side pocket portion does accrue expenses, the fund manager can either retain a hold back from withdrawals to offset future expenses or offset the payable from proceeds of the eventual side pocket s liquidation. Obviously the potential value of the investment is key in making this decision as well. Incentive Allocations Another important consideration in side pockets and their impact on investor capital is the incentive allocation. While some documents state that the incentive allocation is based on a realization event such as a sale or becoming liquid or at the next normal incentive allocation period, some documents are vague. Similarly, sometimes the incentive on the side pocket is calculated independent of the normal trading account while sometimes it is in combination with the normal trading account. Either way, the approach taken should be dictated by the documents and should be approved by the fund auditor and attorney. Disclosures When a fund side pockets an investment, disclosure to investors should be made to explain the what, when, why and for how long. Investor statements can be noted in a variety of ways to assist in this transparency. The year-end audit will also provide specific information pertaining to the side pocket including limitations on participation and valuation. Offshore Structures Side pockets are less common in offshore funds due to the added complexities of share accounting as well as apparent higher levels of concern about liquidity by non-us investors. Typically the side pocket is purchased in a special class with new classes or series for each transaction. Capital is obtained via share redemptions from existing normal series. Expense Allocations. Since participation in a side pocket class is not proportional with respect to all normal classes or series of shares, expenses attributable to side pocket shares must either be pre-funded (with a cash reserve held in each Class) or funded periodically by specific equivalent share redemptions from participants other holdings ALPS [email protected] web

3 Side Pocket Investments continued Incentive Compensation. In a conventional offshore fund, incentive fees are charged separately to the series within each class. Accordingly, there is no conventional option to determine an incentive fee based on aggregate performance in combination with the normal trading account. ALPS Reporting Results in Side Pocket Funds It is customary for ALPS to provide two types of participant-oriented reports on funds we administer. One is the Investor Statement for the period that contains capital account values and other details unique to each investor. The other is the Performance Report which is a fund level view of performance usually from fund inception, with selected statistics and comparisons with market indexes (plus all the notes that would be appropriate). Because side pockets are not shared by all investors, they are not typically included in a fund-level report of performance. An investor or prospect seeking information about side pocket results would normally be shown more qualitative information plus economic outcomes for side pocketed positions. It is standard practice to report the normal capital account and side pocket capital separately. There are several reasons why: The percentage return on normal comingled capital can be considered very accurate. Adding in side pocket valuations, which are typically not accurate on an interim basis, diminishes the value of the participant statement. Participant returns can vary slightly due to fee arrangements and timing, but differences would magnify if side pockets were included. Side pocket pay-offs (or write-downs) typically are event-driven: the company has an IPO; defaults; or there is a significant financing that justifies a price change. In many cases, a side pocket that is held at a static value, or with just small adjustments at audit time, may rocket or plunge in a single month when valuation becomes apparent. Since it is likely that the result in question was actually earned over a longer time period, plugging that number into a monthly return for an investor may be misleading. For these reasons, reporting provided by ALPS defaults to show a percentage return only on normal capital and properly notes that on the statements. For special cases, where the above objections are deemed irrelevant, or legal counsel advises a different approach, ALPS may be able to employ other processes to include side pockets in individual returns on participant statements. Conclusion There is a time and place for a side pocket in a fund. Whether the creation of the side pocket came about because of an opportunity to invest in an illiquid or hard to value investment or because of an unfortunate turn of events affecting the liquidity of the portfolio, the ultimate goal should be fairness and transparency to existing and new investors. Because of the new complexity they add, materiality must also play a part. It is always advisable to consult with fund counsel, auditors and administrator to make a well informed decision specific to each fund. This material has been prepared by ALPS for general informational purposes only. It does not constitute tax, legal or investment advice, and is presented without any warranty as to its accuracy or completeness or whether it reflects the most current developments. ALPS does not provide tax, legal or investment advice. You are urged to consult your own tax, legal and investment advisors ALPS [email protected] web

4 Side-Pocket Checklist for Fund Document Review Side-pocketed assets, plus the expenses and fees that relate to both the commingled and side-pocketed assets, create a number of accounting complexities that should be considered and addressed within a fund s offering documents. This discussion addresses the common accounting and structural issues associated with side-pockets and provides a rudimentary checklist for document review. Note: One drafting strategy that is especially relevant to side pocket complexity is the use of generalities versus specifics whenever possible. While it is important to understand the specific choices outlined below and to communicate those choices to the administrator and auditor, it may be possible to simplify things in the offering documents. An expense discussion, for example, might be generalized by saying, Each Limited Partner shall bear its share of fund expenses and fees attributable to its side pocket investments, with such allocation procedures and adjustments as the General Partner, in its sole discretion, may deem necessary. Definitions for this Checklist 1. SS is a Side-pocket Security or Special Situation investment. 2. SSA is a Side-pocket Sub Account a participant s interest in a specific SS. 3. NCA is the normal capital account commingled undivided interest in the liquid securities portfolio. When Side Pockets Apply Define illiquid securities and state general conditions when the fund s manager may elect to side pocket an illiquid security and when it may not. Is there a general threshold based on individual position or aggregate capital size? Example: If less than 10% of portfolio is illiquid, fund will generally commingle; if a SS purchase would cause the percentage to exceed 10%, fund will generally sidepocket new purchases or perhaps some of the existing ones. What are the conditions where a SS could cease to be in a sidepocket (even if still illiquid)? Limits Does the fund specify fund-level or participant-level limits? If the limit is defined as a percentage of overall fund capital, individual early investors capital in SSs could easily exceed the fund-level limits. For example, if a new fund immediately side-pockets to a 15% limit, the initial investors will have 15% in SSAs. If fund size then doubles and the fund is again taken up to a 15% fund-level limit in side-pockets, the first investors will have 22.5% in SSAs; the second group will have 7.5%. Is there language which limits allocations to SSAs? For example, by partnership percentage, subject to the X% limit. Are disclosures appropriate in either case? If solely a fund-level limit, consider disclosing that individual participants interests in SSAs may exceed the general fund limit. If a participant-level limit, consider disclosing that some investors may not participate fully or at all in some investment opportunities because of the limit. Note: In a fund with participant-level limits, the capital available for side-pockets will be the sum of capital determined to be available participant-by-participant ALPS [email protected] web

5 Side-Pocket Checklist for Fund Document Review continued Allocations For fund-level limits, we recommend defining SSA participation as based on either aggregate (NCA plus SSA) capital partnership percentages or just NCA partnership percentages at the time of acquisition. For participant-level limits, we recommend defining the limit based on either current or contributed capital; then, allocations to SSAs by partnership percentage, subject to the X% limit. This method will eventually consume 100% of an investor s potential SSA capital. After X% of capital is in SSAs, no participation in later transactions. Note: Avoid proportionality tied to total available capital for SSAs. Unless 100% of an investor s remaining SSA capital is consumed by one last purchase, the investor would continue to have diminishing participations in each subsequent SSA, since they will always have some proportion of available SSA capital available. The proportion allocated to earlierarriving investors will decline over time, so a provision to terminate future de minimis SSA participation would have to exist. One negative consequence is that insignificant participations in later SSAs will cause reporting and accounting complexities with likely minimal economic benefit. Timing Ensure that establishing a SSA doesn t trigger a fiscal period mid-month. Since a fund usually uses monthly fiscal periods, use partnership percentages at the beginning of a month to determine participation. Record liquidations as capital and profits coming back into NCAs as of month-end. Expenses and Fees How are fund-wide expenses allocated to SSAs? If offering documents contain specific expense allocation language, a definition would likely be needed for a partnership percentage that includes both NCA and SSAs. Otherwise, SSAs will not pay their share of expenses. Where does cash for fees and expenses come from? From NCA SSA is set up with a cash reserve for expenses and fees If LP withdraws from NCA? Minimal NCA balance required to be retained for fees and expenses? Fees and expenses accrue as a payable from proceeds of eventual SSA liquidation Interest charged? What adjustments would occur if SSA becomes valueless? ALPS [email protected] web

6 Side-Pocket Checklist for Fund Document Review continued Valuations Fair Value is determined how often and how does it affect asset-based fees? Affects if either upward or downward Only affects if valuation is downward Doesn t affect Incentive Allocations Universally, changes in valuations do not result in incentive allocations until a realization event occurs such as a sale or if the security becomes freely tradable as a result of an IPO. The incentive charge can occur either: 1. At the next normal Allocation Time after the proceeds of sale of the SS are re-contributed to the NCA Note this means SSA incentives are conditioned on NCA high water mark. Need to assess fund document language re capital moves to and from SSA Ensure that the transfer of assets from NCA to SSA is handled as a withdrawal from the NCA, so that it doesn t become a loss to be made up. To ensure that gain and loss are accurate, the re-contribution will contain a capital component equal to original transfer from NCA to SSA, plus an income amount equal to the P&L on the SSA. 2. Or, in the SSA at the time of liquidation. Independent of NCA high water mark? Some other mechanism of recognizing NCA high water mark? Some method of recognizing aggregate SSA high water mark? Considerations RE Follow-on Investments If the SS investment is a commitment to a private equity or venture capital fund where cash calls occur in installments over a period of time, there should be special procedures outlined related to funding. Maintaining initial proportions. To avoid a number of issues re interim valuation and fairness, the participants and proportions in any single SS should be kept constant over the funding period. However, the simplest solution taking the entire commitment amount into the SSA initially is usually unacceptable because of the distaste for cash. Accordingly, there will often be sequential contributions to a single SSA from the same participants in the same original proportions, Withdrawals. There should be limits on NCA withdrawals equal to each investor s share of any commitments not yet called. What if NCA returns are negative and, as a result, the withdrawal limits weren t sufficient? In that case, one solution may be a new SSA (and new investor mix) to cover the shortfall. If the amount is de minimis, it may be appropriate for the fund as a whole to make the investment and treat that small interest as an ordinary asset rather than a side pocket ALPS [email protected] web

7 Side-Pocket Checklist for Fund Document Review continued Cash availability. Cash calls on VC and PE funds typically must be met within 10 days or so. According, there must be provisions to access cash or liquidate other investments in time to meet the calls. Timing. Mid-month funding of cash calls should be considered withdrawals from NCAs as of the beginning of the period. Disclosures If fund-level limits exist, note that a 15% fund-level limit does not mean that individuals may not significantly exceed that limit. If participant-level limits exist, disclose that some investors may not participate fully or at all in some side-pockets because of the limit. Illiquidity; lack of accurate valuation; indeterminate allocation amount; etc. Offshore Structures Note: SSAs are less common in offshore funds due to the added complexities of share accounting as well as apparent higher levels of concern about liquidity by non-us investors. There are a number of accounting issues: 1. Structure. SSs are purchased in a SS Class with new classes or series for each SS transaction. Capital is obtained via share redemptions from existing normal series. 2. Expense allocations. Since participation in a SS Class is not proportional with respect to all normal classes or series of shares, expenses attributable to SS shares must either be pre-funded (with a cash reserve held in each SS Class) or funded periodically by specific equivalent share redemptions from participants other holdings. Which holdings? Documents should probably suggest FIFO or permit Administrator to choose - proportional redemptions among several share series within a class would be cumbersome. When? Monthly redemptions would create a tracking nightmare for investors as well as the administrator, so it s best to specify that it occur on a quarterly or annual basis. 3. Incentive compensation. In a conventional offshore fund, incentive fees are charged separately to the series within each class. Accordingly, there is no conventional option to determine an incentive fee based on aggregate performance of both normal and SS shares. It may be possible to reduce the level of complexity in an offshore fund by utilizing a memorandum master feeder arrangement where memorandum accounts are maintained in a master-level partnership for each feeder-fund participant. See the Hedge Fund Elements discussion on Memorandum Master Feeders. The Side Pocket Parameter Table is located on the following page. This material has been prepared by ALPS for general informational purposes only. It does not constitute tax, legal or investment advice, and is presented without any warranty as to its accuracy or completeness or whether it reflects the most current developments. ALPS does not provide tax, legal or investment advice. You are urged to consult your own tax, legal and investment advisors ALPS [email protected] web

8 Side Pocket Parameter Table Fund: o When side pocket accounts are established o All illiquid securities at time of purchase o If a single illiquid security exceeds % of capital at time of acquisition o If illiquid securities, in aggregate, exceed % of capital Limits o Limited to % of fund capital at the time of most recent acquisition o Limited to % on a participant level; allocated by partnership percentage, subject to that limit o based on current capital o based on contributed capital Expenses and Fees o Paid from normal capital accounts o Limit withdrawals while an investor still has side pockets, requiring a minimum of % in normal capital o No withdrawal limit; expense share paid by fund overall; reimbursed when SSA is sold, with interest to fund overall at % rate o Reserve of % to be established in each SSA Incentive Allocation o Incentive rate on side pockets is different from normal accounts: %. o Charged separately in each side pocket at the time of a realization event o Charged at the side pocket level, with a high water mark related to other side pockets o Charged after a realization event when proceeds are transferred to investors normal capital accounts with a high water mark related to the overall capital account (including other closed side pockets) at the normal incentive calculation period Valuations & Asset-based Fees o Affects fees if valuations go either upward or downward o Affects only if valuation is downward o Doesn t affect based solely on cost o Side pocket capital excluded from asset-based fees This material has been prepared by ALPS for general informational purposes only. It does not constitute tax, legal or investment advice, and is presented without any warranty as to its accuracy or completeness or whether it reflects the most current developments. ALPS does not provide tax, legal or investment advice. You are urged to consult your own tax, legal and investment advisors ALPS ALP /14 [email protected] web