Side Pockets can be equated to a form of solitary confinement for assets who misbehave. While a relatively new concept in the Irish Funds Industry, they have been utilised in some offshore jurisdictions for quite some time. They operate to reduce risk for existing, redeeming and prospective shareholders in a Qualifying Investor Fund (QIF) and have proven a useful tool for wily investment managers to increase a fund's alpha by sidelining illiquid elements of their portfolios thereby boosting returns.
Given that the Financial Regulator has recently approved the concept of side pockets and the fact that the Irish Stock Exchange has also introduced rules clarifying disclosure requirements for funds intending to create side pockets, it may be helpful to take a closer look at how this mechanism works.
An Overview of Side-Pockets
A Side Pocket is a type of share class used by QIFs to separate illiquid assets from other more liquid investments. Once an investment is transferred into a side pocket only those investors in the fund when the share class is created will be entitled to shares in the side pocket.
There are many reasons why certain types of assets become illiquid or difficult to value. When this happens it becomes a drag on the performance of a fund portfolio and makes the fund an undesirable vehicle for prospective investors. This is best illustrated by examining how side pockets protect and benefit the categories listed below.
- Existing Shareholders
- Redeeming Shareholders
- New Shareholders
- Investment Managers
Existing shareholders in a QIF that holds an illiquid asset may be prejudiced if other shareholders decide to redeem out of the fund. If the proceeds of that redemption are based on an overly optimistic valuation of the illiquid element of the portfolio this will result in an erosion of the liquid assets and a contortion of the Net Asset Value of the fund. If the illiquid asset is transferred into a side pocket the redeeming investor will only be entitled to redeem the value of their holding in the side pocket once the investment has been fully realised for fair value.
If a shareholder decides to redeem or partially redeem his shareholding from a QIF that holds an illiquid asset he may not receive his full entitlement if the valuation of the asset was underestimated. The advantage of using a side pocket is that the proportion of the fund which is represented by the illiquid asset is only redeemed when it is capable of being accurately valued. This avoids prejudicing the redeeming shareholders and assures that the Net Asset Value of the fund is accurate.
New shareholders will have no entitlement to shares in the side pocket housing the illiquid assets. In this way a new investor will be comfortable that their investment will not be indirectly used to fund redemptions that could erode the liquid element of the fund.
In the current climate where investment managers find it increasingly difficult to achieve a significant alpha, more and more attention is being focused on riskier investments that provide superior returns. The nature of these investments often means they are difficult to value. In instances such as this investment managers see side pockets as a very useful tool in allowing them greater freedom to speculate.
The Creation of Side Pockets
The regulatory climate of the fund industry in Ireland and the necessity to build side pockets into the existing structures has generated a lot of discussion. The general consensus would now seem to favour the creation of a separate class of shares representing a proportional division of the existing shareholders entitlements to the illiquid asset.
In a situation where a fund intends to create a side pocket the following issues need to be taken into account:
- The constitutional documentation of the fund should be amended to cater for the creation of side pockets. This will include making the necessary disclosures in the prospectus;
- The creation of the side pocket represents a change in the terms upon which investors originally invested in the fund and consequently the approval of the shareholders will be required to create the side pocket. This approval can be obtained either at a general meeting (in the case of an investment company) or the written consent of all the shareholders;
- The existing shareholders will receive a pro-rata share of the new class proportionate to their holding in the fund at the time of creation of the class;
- The new class will benefit from any interest, dividend or other income accruing to the side pocketed investment;
- Shares in the new side pocket class can only be redeemed when the illiquid assets can be valued accurately;
- The new class of shares will be valued on each dealing day and the administrator will provide details of the valuation on the financial statements; and
- Any fees attributable to the illiquid portion will be accrued and paid once the illiquid assets are realised.
The Financial Regulator has stated that a maximum of 20% of the Net Asset Value of the fund may be deposited in a side pocket. However, it has also noted that this is not a hard and fast rule and in some circumstances this may need to be increased. A number of factors such as a reduction in the value or an increase in the number of redemptions of the fund will influence this. Any increase in this 20% limit would, however, need the approval of the Financial Regulator.
In April 2006 the Irish Stock Exchange published Policy Note 2/06 which provides that illiquid assets apportioned to a separate share class should not exceed 30% of the fund's gross assets.
Side pockets seem on face value to be a neat mechanism to assist in ensuring equality of treatment between shareholders. However as the area evolves a number of key concerns have emerged. It is worthwhile to consider some of these briefly:
- Some parties feel side pockets are just another way of protecting manager's fees by putting certain investments into a magic box - never to be seen again.
- Complex issues have arisen surrounding the crystallisation of performance fees and the adjustment of High Water Marks. This just serves to highlight the potential conflict of interests that may emerge over time.
- It is essential that the framework for how and when side pockets can be created be laid out in order to avoid contentious issues arising from the extent of the manager's discretion to designate investments into a side pocket.
- Creditors agreements should be put in place where the side-pocketed investment has been leveraged. This is necessary to prevent creditors having recourse to the liquid element of the portfolio.
- Using side pockets has been viewed as adding a layer of secrecy and susceptible to abuse if the side pocket investments are not included in the fee calculations.
The ability to deal with illiquid assets in an open-ended fund structure will allow QIFs to continue to market the positive aspects of their portfolios and attract new investment without compromising existing shareholders. The recent acknowledgement of this by the Financial Regulator and the Irish Stock Exchange is a welcome development for Qualifying Investor structures in Ireland.