Side Pockets and Valuation
What's inside your side pocket? The answer may shock you. That's the gist of a recent article about investments that are tucked away, not to see the light of day until the positions are sold or marked down in anticipation of bad news. In "Street Sleuth: 'Side-Pocket' Accounts of Hedge Funds Studied" Wall Street Journal, August 4, 2006, reporters Gregory Zuckerman and Scott Patterson write that funds have been known to place large chunks of their portfolio in side pockets. Any investor seeking to withdraw money may find it difficult, sometimes facing "limits on their ability to withdraw their money, terms that are put in place so a fund can avoid being forced to sell investments at a sizable loss if a number of investors suddenly want their money back."
They cite Securities and Exchange Commissioner Roel Campos who addressed side pockets as part of his remarks before the SIA Hedge Funds & Alternative Investments Conference on June 14, 2006.
Hedge funds may hide poor-performing assets in side pocket accounts to exclude such assets from the fund's valuation for purposes of calculating performance fees. Some hedge funds require leaving some of the investment in side pockets as a condition for redemption, even though the condition was not disclosed in the investment agreement. On the larger scale, there is the potential for excessive leverage, the concentration of positions, the dependence of valuations upon complex proprietary models, and operational risks for settlement and clearance systems. There is also the risk that hedge funds will all exit at the same time - as purportedly occurred in the 1997/8 Asia Financial Crisis. Performance fee structures give hedge funds an incentive to engage in risky strategies that may not be fully disclosed, and some advisers may not have sufficient risk management processes in place.
Complicating things is the fact that a hedge fund can have multiple side pockets. For a fund of funds manager, the situation could be daunting if he or she allocates money to a large number of funds, each with multiple side pockets.
Supporters of side pockets argue that valuing investments under less than ideal conditions is worse than putting them aside for awhile. They advocate the use of side pockets so that investments they describe as carefully selected have a chance to grow.
Nevertheless, there are things one can do. Even when formal valuations are not performed by an independent appraiser, the use of a qualitative risk driver matrix offers a relatively low-cost form of discipline to get investors thinking about scenarios that might spell trouble. The idea is to both identify factors that could depress value and think about the likelihood of occurrence. For example, the value of equity issued by a closely-held airline company that does not hedge will no doubt drop as oil prices rise. (This author is surprised by the number of investors who have not taken this rather simple step in assessing the risk elements of their portfolio.)
More and more pundits describe a blurring of the lines between hedge funds (some of them anyhow) and private equity funds. The Mid-Atlantic Hedge Fund Association is devoting an entire meeting to this topic on October 12. Founding member and chairman of the board of this educational organization, Dechert attorney Brian Vargo describes the three-hour program as a lively discussion that is sure to include valuation as one of several challenges associated with the trend towards convergence.
In case you missed it, the author wrote about the importance of getting independent opinions of value or having an outsider review the valuation process already in place on June 18, 2006. Click here to read the post.
