Side Pocket Account
A side pocket account is the specific segregated account structure through which a hedge fund operationally implements a side pocket, maintaining separate accounting records, NAV calculations, and investor allocations for illiquid or hard-to-value assets isolated from the main fund. It is the operational manifestation of the side pocket concept, governed by explicit provisions in the fund's limited partnership agreement or operating documents.
Key takeaways
- Side pocket accounts are maintained separately on the fund's books, with their own series of interests and distinct NAV per share calculations independent of the main fund.
- Transfer agents and fund administrators must track each investor's proportional interest in the side pocket account, including any changes resulting from redemptions or transfers that occurred after the side pocket was established.
- Valuation of assets in a side pocket account is typically performed by the fund manager or general partner subject to independent review, using mark-to-model or third-party specialist valuation given the absence of market prices.
- The expense structure of side pocket accounts — management fees, administrative costs, legal fees associated with the underlying investment — must be clearly disclosed in the fund's offering memorandum.
- Auditors apply heightened scrutiny to side pocket accounts due to valuation subjectivity and the potential for conflicts of interest between the manager and investors.
Explanation
At the operational level, a side pocket account functions as a sub-fund within the main hedge fund structure. When a general partner designates an asset for side pocketing, the fund's administrator creates a new series or class of fund interests specifically for that asset. The asset is removed from the main fund's NAV calculation and transferred to the new series. Each investor's subscription to the side pocket series is proportional to their ownership percentage in the main fund at the time of designation.
The accounting treatment requires careful management. The administrator must maintain parallel sets of books: one for the main fund reflecting ongoing trading activity, and one for each active side pocket series showing the asset's carrying value, any income or distributions received, accrued expenses, and the current NAV per interest. When the underlying asset generates income (e.g., interest payments on a distressed bond), that income flows into the side pocket account and may be distributed to investors periodically or reinvested.
Valuation is the most challenging operational aspect of side pocket accounts. Without observable market prices, the manager must establish a fair value methodology: discounted cash flow analysis, comparable transactions, independent appraisal from a specialized valuation firm, or purchase/sale offers received from third parties. Fund documents typically specify the valuation methodology and the frequency of independent review. The Securities and Exchange Commission has emphasized through enforcement actions that fair value policies must be consistently applied and faithfully documented.
Investors who redeem from the main fund after a side pocket is established retain their interests in the side pocket account. This creates an administrative challenge: the fund must continue to service investor relationships with former LPs who have no remaining investment in the main fund but hold side pocket interests worth potentially millions of dollars. Transfer agents must maintain accurate records of these former investors' contact information, beneficial ownership, tax identifications, and distribution instructions — sometimes for periods of five to ten years or more.
From a prime broker perspective, assets in side pocket accounts may or may not be eligible for financing or securities lending depending on their nature. Physical commodities, private equity interests, or distressed loans typically cannot serve as margin collateral, while exchange-listed securities in a side pocket (if any) may retain their borrowing value. The prime broker's legal documentation must be reviewed to clarify whether side pocket assets fall within the general financing agreement or require separate arrangements.
Example
A $200 million macro hedge fund holds a $15 million position in subordinated notes of an infrastructure company that has suspended interest payments and entered an out-of-court restructuring. The administrator creates a new 'Series B Side Pocket' with interests allocated to all current investors proportionally. Investor A, who holds 5% of the main fund ($10 million of $200 million), receives a Series B interest representing 5% of the side pocket's $15 million face value ($750,000). Investor A then redeems his main fund position completely. He retains his Series B interest. Eighteen months later, the restructuring concludes with a 60-cent recovery — the side pocket distributes $9 million ($15M × 60%) to all Series B interest holders. Investor A receives $450,000 (5% × $9 million) via wire transfer to his account on file with the transfer agent.
Related terms
Bond Discounted Cash Flow Equity Exchange Expense Ratio Face Value General Partner Hedge Fund Lp Agreement Margin Nav Calculation Prime Broker