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Hedge funds increase use of 'side pocket' investments

By Jeff Benjamin
InvestmentNews.com
December 12, 2005

DETROIT - Side-pocket investments - which can add hidden risk to portfolios - are gaining popularity among hedge fund managers as the industry pushes further into the private-equity space in search of alpha.

Hedge fund managers typically will create a side pocket that is separate from the rest of the fund to hold illiquid and difficult-to-price assets, such as stakes in privately held companies.

Due to the opaque nature of the industry, it would be difficult to say exactly how many of the estimated 8,000 hedge funds use side pockets, but industry sources said that it is on the rise. In some cases, side-pocket investments represent as much as 30% of a fund's portfolio, according to published reports.

"Side pockets are kind of misunderstood, and still largely a private topic, but it's definitely becoming more prevalent," said Joseph Omansky, founder of Sky Fund LLC, an East Brunswick, N.J.-based hedge fund research firm.

"The hedge fund industry likes to keep them private, because it gives them more flexibility to exclude or include certain investments when calculating their net asset value," he added. "It's a recipe for fraud, which is why it's important for investors to know what portion of a fund is being self-priced or placed in a side pocket."

Major concern

Although representatives from across the $1 trillion hedge fund industry have expressed a range of views on the use of side pockets by portfolio managers, it is a virtually unanimous belief that the onus is on investors to know when and how the management strategy is being applied.

"The investor needs to know exactly what he's getting into, and if the information [regarding side pockets] is vague, the investor either needs to feel comfortable with that or go elsewhere," said Raymond Higgins, chief executive of Higgins Capital Management Inc. in La Jolla, Calif.

A major concern is that because the assets held in the side pocket are usually excluded from a hedge fund's monthly or quarterly performance calculations, the investors could be getting an incomplete or inaccurate picture of performance.

Mr. Higgins, who advises clients on hedge fund investing strategies, acknowledged the potential for fraud when it comes to the use of side pockets but pointed out that it is all part of investing in alternative strategies.

"If you want the full transparency and liquidity of a mutual fund, you should buy a mutual fund," he said. "But investors who turn to the alternative space want something different, and that means the rules of the game are different."

The Securities and Exchange Commission studied the use of side pockets by hedge fund managers in 2001 as part of a comprehensive evaluation of the hedge fund industry.

The SEC's research laid the foundation for the rule that requires most hedge fund managers to register as investment advisers, beginning in February.

"Side pockets exist, and they have a legitimate reason to exist," said Robert Plaze, associate director of the SEC's division of investment management. "We don't see all the assets, but it seems as more hedge fund managers move into private equity, there are more side pockets."

While Mr. Plaze acknowledged the potential for a manager to hide poorly performing assets in a side pocket in order to avoid the drag on performance fees, he also believes that side pockets can protect investors.

For example, he said, by establishing a side pocket to hold illiquid assets, the hedge fund partnership ensures that all investors are equally exposed to the entire portfolio.

"In a sense, the side pockets prevent investors who are exiting the fund first from taking all the liquid assets and leaving the illiquid assets," Mr. Plaze said.

Much of the recent hoopla with regard to side pockets is driven by the hedge fund industry's migration into private equity, which quickly is being accepted as part of the industry's evolution.

The trend toward private-equity investing is being driven by a perfect storm of events, according to Charles Gradante, managing principal of Hennessee Hedge Fund Advisory Group LLC in New York.

"A lot of small, private companies are underfunded, and they need financing, and they can't get it from commercial banking and investment banking," he said. "In the traditional channels, the standards [for private-equity investing] have been elevated, and that has left a whole sector of companies without financing."

This increased demand is coupled with the pursuit of performance in an increasingly crowded hedge fund marketplace, Mr. Gradante said.

Regardless of the direction of the industry, some investors don't want any part of managers' using side pockets.

"We don't deal with hedge funds that use side pockets, because there are multiple problems," said Joseph Nicholas, chairman and chief executive of HFR Asset Management LLC, a $4 billion hedge fund investing platform based in Chicago.

"When hedge funds use side pockets, you don't get the true picture of the investment," he added. "If investors fully understand what they're getting into, there's nothing wrong with side pockets, but if you see a good track record and quarterly liquidity in a fund with a side pocket, you might find out you can't actually get out when you want to, and the performance doesn't include the side pocket."

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Side pockets are kind of misunderstood, and still largely a private topic, but it's definitely becoming more prevalent, said Joseph Omansky, founder of Sky Fund LLC, an East Brunswick, N.J.-based hedge fund research firm.

The hedge fund industry likes to keep them private, because it gives them more flexibility to exclude or include certain investments when calculating their net asset value

It's a recipe for fraud, which is why it's important for investors to know what portion of a fund is being self-priced or placed in a side pocket.


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