Side pockets have been in the news recently, but they are far from a novelty.
During the Global Financial Crisis, or GFC, when investors wanted to pull out in droves, hedge fund managers in the U.S. were forced to liquidate assets in an unstable market, at bargain basement prices, which would accelerate the deterioration of the fund. Obviously, a unilateral withdrawing of assets would leave the fund vulnerable and would harm the investors who were not looking to cash out. This is when side pockets became a flashpoint.
Creating side pockets was one of the tactics used by hedge funds during the credit crisis, when they could not sell assets to meet redemptions.
While hedge funds began to use side pockets to stash illiquid securities and avoid losses, there were concerns, specifically with regards to aspects such as valuation and price discovery in the case of illiquid assets. By 2010, the U.S. Securities and Exchange Commission, or SEC, heightened scrutiny of the practice and charged a few hedge fund managers with fraud, claiming that they overvalued illiquid assets placed in a side pocket.
Dan Kemp, the CIO at Morningstar Investment Management EMEA, comments on this very aspect: "Side pocketing is based on the idea that the fair value of the illiquid asset is far higher than the current selling price. Why that may well be true (and is at the heart of every valuation driven investment approach), it could also be used as a way of maintaining an inflated valuation."
But it was not restricted to the GFC. When Hurricane Sandy hit in 2012, Credit Suisse (in its dedicated insurance-linked securities, or ILS) decided to side pocket investments potentially exposed to losses. The side pocket was to protect new investors in the Credit Suisse Iris Low Volatility Plus Fund from exposure to losses caused by Sandy.
In 2017, The Wall Street Journal referred to side pockets as the ‘crisis-era tool’ and noted that there has not been a widespread return of side pockets, but the practice could tick up again if liquidity in markets disappears or funds continue to get hit with larger-than-expected redemption requests. The article cited the example of Claren Road Asset Management that effectively sidepocketed assets. It split its hedge funds into portfolios for remaining and exiting investors after it was hit with redemption requests for $2 billion, or roughly half its assets under management at the time. The move gave the asset managers time to pay out its redeeming investors.
Not just the U.S., side pockets are found across the globe.
In 2014, African Bank, which was South Africa’s largest provider of unsecured loans, failed. A report by IOSCO, noted that 10 retail South African money market funds got adversely hit as a result. They addressed this by enforcing a single day loss and permitting side-pocketing of the illiquid asset. Some funds initially experienced large outflows, which stabilized once side-pocketing was introduced. The affected funds dealt with withdrawals and one fund substituted the illiquid assets with cash from its sponsor.
A January 2018 post by the University of Oxford had some interesting pointers:
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U.S.: side pockets are not allowed for open-ended or closed-ended funds and only hedge funds can exercise this tool
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Italy: allows side pockets for non-retail funds, provided the interests of the funds’ participants are upheld.
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U.K.: side pockets can be used for alternative investment funds only
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Australia, Brazil, France, Hong Kong, South Africa, Singapore: allow side-pockets to be used irrespective of the category of funds
Has it happened in India?
In 2015, JP Morgan India Treasury Fund and JP Morgan India Short Term Income Fund had a collective exposure of around Rs 200 crore to Amtek Auto. When it turned out that the auto component maker may turn out to be one of the biggest corporate bond defaulters in years, and debate raged on whether rating agencies were napping on the job, the NAVs of the schemes dropped, investors panicked, leading to heavy redemptions. Subsequently, the fund gated redemptions to avoid losses. The exposure of Amtek bonds was side pocketed and unit holders, as on a record date, were provided units of the side-pocketed asset. Purchase and redemption of the latter were not allowed, while redemption and purchase were regularised in the liquid asset exposure.
Later, SEBI mulled bringing in side pockets but probably feared it would become a dumping ground for bad assets and encourage fund managers to take unnecessary risks. A safety net would encourage risk taking, is what was reported.
However, the IL&FS debacle and stress amongst NBFCs have forced the regulator to come up with guidelines, which stated that it will only be permitted in the case of stressed debt paper that falls below investment grade.
A welcome move?
A side pocket is an account that is established to segregate illiquid assets from the rest of the portfolio. These investments can be isolated until the market conditions improve and the asset can be sold at price that better reflects its intrinsic value. The Net Asset Value, or NAV, of the fund will then reflect the actual value of the liquid assets. A different NAV will be allocated to the side-pocketed assets. So instead of redemption being halted in the entire fund, it’s just the side pocketed portion that will be frozen. SEBI believes that this would protect retail investors because in a crisis, it is the institutional players who move quickly with early redemptions leaving retail investors stuck.
Morningstar India’s director of fund research Kaustubh Belapurkar, opines that allowing a segregated portfolio to be created, permits asset managers to move bonds which undergo a credit event. This prevents redemption panic and will allow the primary portfolio to operate as usual, without any undue liquidity stress. Moreover, in the Indian context, where secondary market liquidity is low, side-pocketing will help keep liquidity intact in the main portfolio, which remains healthy.
Morningstar requested a few AMCs to share their views. However, they reverted with a “we are not comfortable doing so” or “we would not like to be quoted on the issue”.
If you would like to read more on the concept, the CFA Institute explained side pockets in great detail in Guidance Statement on Alternative Investment Strategies and Structures.
SEBI’s circular on guidelines for side pockets can be obtained here.
