21 October 2021 - Over the last 12 months, hedge funds in Asia have been allocating increasing sums into “side pockets” – ring-fenced assets within strategies which are typically used to purchase illiquid investments such as pre-IPO companies.
Total assets in these strategies now stand at $26.4bn across Citco group of companies’ hedge fund client base, with an increase of $3.9bn in allocated assets in side pockets year-to-date.
Hedge funds across the Asia Pacific region in particular are in the driving seat as they continue to push deeper into areas like pre-IPO investments which have long been dominated by private equity. Across Asia-focused mandates, investments in side pockets have increased by almost 200% in the last two-and-a-half years, up from $3.3bn at the end of 2018 to $9.4bn by the end of June this year. The use of side pockets continues to gain momentum with Asia-focused hedge funds this year – as a percentage of AUA they have climbed from 4.4% at the end of 2020 to 5.1% in the first six months of 2021.
However, while side pockets are once again big business in Asia, it is not the case across the globe as a whole. Across our own client base, the AsiaPac region has three times more side pockets per capita than our ex-Asia clients globally.
In truth, this is something of a resurgence for side pockets, which were popular in the previous decade only to see investor appetite dip post the Global Financial Crisis in 2008.
The current side pocket approach is targeted to specific opportunities, and is different to the trend seen around the GFC where, in some cases, side pockets were used to dump non-performing investments to meet their redemption activity.
Part of the appeal in the Asia Pacific region currently is the sheer volume of “unicorn” companies emerging which, while being private rather than public, are still valued at more than $1bn.
According to CB Insights, Asia has more than a quarter of the world’s 700 unicorns, with China at 118 companies and growing, and India rising up the rankings to come third worldwide with 24.
Side pockets are a natural way for hedge funds to access these types of pre-IPO companies, using them as short-term investment options where managers are expecting names to IPO within 6-24 months.
The broader trend itself is likely to be far from short-term for one simple reason: there are fewer places than ever to generate a return. Hedge funds are under pressure to deal with the challenges of sky-high valuations across many major global equity markets, coupled with record low bond yields, and areas like unlisted equity can help provide the answers.
Nonetheless, there are some key considerations to review before making such investments. Below we outline five major ones for hedge funds to contemplate.
It is vital that that any hedge fund has a process for establishing and documenting a framework of rules which govern how the assets in the side pocket will be treated. This needs to be shared with all parties, from the investment managers and BODs, to the investors, auditors and administrators.
2. Opt In/Opt Out Process
It should be clear who is exposed to these side pockets within a hedge fund, and who is not. It is best practice to segregate these assets at a class level for increased control at the onset of capital activity rather than at the time of investment.
3. Investment Limit Monitoring
It can be done at a fund or investor level and should be clearly documented in the PPM. However, globally, hedge funds tend to track at the fund level to determine the percentage of private investments that can be in the fund.
The most relevant accounting standards require financial statements to reflect assets and liabilities at fair value, and the same applies to side pockets. Ideally, the Fund Valuation Policy would set out the procedures and methodologies to be used to determine this, but there are also considerations to be made around ongoing valuations and the use of specialist evaluators.
Generally, the fees for investments that are side pocketed follow the same or similar terms as those in the liquid part of the portfolio with the exception of realizing incentive fee upon disposition of the asset.
Funds also need to consider if the management fees will be accrued in the side pocket until realization, or offset again the liquid class. Additionally, should you consider netting the incentive fee for the side pocket with the liquid class in the event that there is a loss?
Of course, there are exceptions to every rule, and some side pockets have full PE waterfall calculations built-in to their PPM.
By Donna Hutchings, Managing Director, Citco Fund Services (Singapore) Pte. Ltd.