Side Pocket
A side pocket is a bucket within a hedge fund that holds illiquid positions, segregated from the main fund's NAV calculation and redemption mechanics. LPs receive proportional side-pocket interest at the time of side-pocket creation; redemptions of side-pocket holdings are tied to the underlying asset's eventual disposition rather than to the fund's regular redemption windows. Used to prevent illiquid positions from contaminating the main fund's liquidity.
Side pockets address a fundamental tension in hedge funds: most hedge funds offer monthly or quarterly redemption, but some opportunities (private investments, distressed debt, real estate) are inherently illiquid with multi-year holding periods. Putting an illiquid position in the main fund creates two problems: (1) the position's NAV is uncertain, distorting the main fund's NAV; (2) redeeming LPs may force liquidation of the illiquid position at distressed prices.
The side-pocket solution: at the time the illiquid position is acquired, the GP creates a side pocket. Each existing LP receives a proportional interest in the side pocket equal to their fund ownership percentage. The side pocket's NAV is reported separately; the fund's main NAV excludes the side-pocket position. Subsequent fund redemptions affect only the main fund; the side-pocket interest is illiquid until the underlying position is disposed of.
The main critique of side pockets is the abuse pattern: a poorly-performing fund GP moves struggling positions to a side pocket to remove them from the main fund's NAV — making the headline performance look better while LPs remain exposed to the underperformance through their side-pocket interest. The post-2008 industry response: stricter LPA language on side-pocket creation (requiring LP advisory board approval, limits on side-pocket percentage of fund), and more transparency in side-pocket NAV reporting.
For LP planning purposes, side-pocket interests are functionally similar to private-fund LP positions — illiquid, multi-year-hold, NAV-lagged. LPs treating them as 'extension of the hedge fund' make a mistake; the side-pocket is essentially a separate private-fund-style investment that happens to share LP allocation with the hedge fund.
Synthetic hedge-fund LP positions should occasionally include side-pocket interests at realistic frequency. Each side-pocket tracks: creation date, original allocation percentage, segregated NAV, illiquid-asset details. Test scenarios should include the long-tail side-pocket case (LP redeems main fund years before side-pocket finally liquidates).
Common pitfalls
- Aggregating side-pocket NAV into main-fund NAV — they're separate; the main fund NAV excludes side-pocket positions.
- Treating side-pocket interests as redeemable through the main fund's mechanism — they aren't; redemption depends on the underlying asset's disposition.
- Forgetting that a former-LP (who fully redeemed the main fund) may still have side-pocket exposure — the side-pocket follows the LP regardless of main-fund-redemption status.
- Aggregating side-pocket performance with main-fund performance — they have different volatility, liquidity, and return profiles.
Examples
Fund LP has 5% ownership of $200M hedge fund = $10M position. Fund acquires illiquid private investment of $20M and side-pockets it. LP automatically receives 5% interest in side-pocket = $1M. Main-fund NAV reduced from $200M to $180M; LP's main-fund position now $9M. LP redeems main fund at year 3 ($10M back, including any P&L). Side-pocket interest persists until underlying private investment is disposed (could take 5+ more years). LP fully exits hedge fund main vehicle but retains $1M side-pocket interest until underlying asset liquidates.