In a marketplace that is becoming more crowded and competitive by the day, many multi-strategy hedge funds have begun looking beyond their traditional hunting grounds for new opportunities.

The general consensus is that, on average, private equity funds have been outperforming hedge funds as of late and many hedge funds have now seen the tremendous potential offered by the comparatively illiquid assets normally considered more the domain of those private equity funds and have decided it is time that they got into the fray. In a break from the norm, a growing number of hedge funds have begun broadening their horizons by investing significant proportions of their portfolios in an increasingly unusual and often illiquid array of assets.

As a consequence, hybrid funds have evolved which combine the liquidity and simplicity of a typical hedge fund with the illiquidity and greater complexity of a typical private equity fund. In many cases, the lines between the two types of funds that once more or less represented the different ends of the spectrum have become somewhat blurred. However, this convergence of approaches has presented the industry with many practical issues which it has had to reckon with and quickly resolve.

Whereas most private equity funds are designed specifically to deal with the inherent difficulties posed by illiquid assets (with no rights for investors to redeem and deferred compensation for fund managers being the norm), most hedge funds, in contrast, have traditionally been designed with relative simplicity in mind (with rights for investors to redeem and compensation for fund managers based on NAV being the norm). By their very nature, illiquid assets do not naturally sit well in the traditional hedge fund structure. As such, the new hybrid structures have, out of necessity, had to develop dual systems (and new devices to go with these systems) within their structures which are effectively able to deal with both liquid and illiquid assets. So called "side pockets" (or "designated investments") were born out of this need.

Side pockets are devices within a hedge fund structure that permit illiquid assets or comparatively hard to value assets (or assets which may become such) to be designated as such and then hived off from the rest of a hedge fund’s portfolio so as to be housed in their own specially created compartments (or side pockets) within the hedge fund. The power to side pocket is normally mandated to the fund manager (with the parameters of their powers being fully disclosed in the offering documents of the hedge fund). Once side pocketed, the assets are treated separately from the rest of the hedge fund’s portfolio with each side pocket having its own distinct (redemption, compensation and such like) provisions which generally prohibit entry into the side pocket by new investors and, likewise, exit from the side pocket by the existing investors. On the side pocketing of assets, existing investors (with an interest in the particular side pocket) are, at that point, effectively locked into that side pocket (as far as those assets are concerned) whilst being free to redeem out their remaining investment in the rest of the hedge fund’s portfolio. Side pockets can thus be thought of as specially creatable sub-funds of a hedge fund with their own unique provisions.

Side pockets have had some bad press as of late. It has been argued that the system is open to abuse by fund managers who wish to massage their figures by shunting poorly performing assets out of the way (into one of the hedge fund’s side pockets) essentially hiding the bad picks in order to artificially hype the performance of the general portfolio (and consequently to inflate their compensation which will be based upon the performance of the hedge fund’s general portfolio). Nonetheless, side pockets are building a favourable following with many investors who see that they are perhaps the fairest way to deal with the difficulties posed by illiquid and comparatively hard to value assets.

Most investors in hedge funds fully understand the risks associated with their investment and are sophisticated enough to understand the concept of side pockets. With proper disclosure of the inherent risks associated with illiquid assets in a fund’s offering documents, there is no reason why side pockets should not be utilized. These, more often than not, avoid the potential pitfalls associated with illiquid assets and, as such, help alleviate inequalities which could otherwise result. For example, these avoid the difficult task of trying to value an illiquid asset each time an investor wishes to enter or exit a hedge fund. Likewise, these avoid the "last man standing" scenario where a hedge fund without side pockets holding a variety of liquid and illiquid assets will inevitably liquidate its liquid assets first in order to redeem out any exiting investors thus leaving the remaining investors stuck with the illiquid assets (and the potential risks associated with these).

Whilst there is little doubt that derivations of side pockets have been utilized by some of the more creative hedge funds for many years, it is only now that they are becoming more mainstream and, as such, gaining more publicity. As with any relatively hot new issue, it is inevitable that there will be some degree of initial skepticism and paranoia from the regulators. However, the industry (investors and service providers included) now has a much better understanding of what side pockets are and how these should be treated and, indeed, their use is now being actively encouraged in many circles.

In many ways, side pockets allow hedge funds to enjoy the best of both worlds – the speed and simplicity of the average hedge fund with the longer term approach of the average private equity fund - all conveniently within the same hedge fund managed by the same fund manager. Ultimately, that can only be of benefit to the investor.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.