A hedge fund with $500 million in assets owns a stake in a private company, bought when the company was preparing a stock market listing. The listing is cancelled. Nobody can say what the stake is worth, and it cannot be sold for months or years. The manager's best estimate is $50 million, or 10% of the fund.
If the stake stays in the main portfolio, every redemption is paid at a net asset value that includes a guess. Investors who leave take cash from the liquid part of the fund, and the ones who stay end up owning a growing share of an asset nobody can price. New investors buy into that guess too.
Hedge funds use side pockets for this situation.
What a side pocket is in a hedge fund
A side pocket is a separate account inside a hedge fund that holds illiquid or hard-to-value assets apart from the main portfolio, owned only by the investors who were in the fund when the assets were moved into it and not redeemable until those assets are sold. Fund documents often call these positions "special" or "designated" investments, and the side pocket is represented by a new class of non-redeemable interests or shares.
The legal form depends on how the fund is organized. A US limited partnership records each partner's side pocket interest in a separate capital account. An offshore fund organized as a company, for example in the Cayman Islands, exchanges part of each investor's ordinary shares for a newly issued class of side pocket shares. The asset stays on the fund's books either way, tracked separately from the liquid portfolio.
In the example above, an investor holding $25 million, or 5% of the fund, would end up with $2.5 million in the side pocket class and $22.5 million in the liquid class. A new investor who subscribes the following month buys only the liquid class. If the original investor redeems everything a year later, they receive the value of their liquid shares and keep the $2.5 million side pocket interest until the stake is sold. If the company is eventually sold and the stake fetches $80 million, that investor's 5% share is $4 million before fees. If it fetches nothing, their share is zero and the new investor never bore any of the loss. These figures are a hypothetical illustration.
How assets move in and out of a side pocket
The sequence is set in the fund's offering memorandum and partnership agreement or articles. Most follow the same order:
- Designation. The manager decides that a position is illiquid or lacks a readily available market price. Some documents allow this only at the time of purchase. Others let the manager move an existing holding into a side pocket later, including in the middle of a market crisis.
- Conversion. Part of every existing investor's holding is redeemed from the liquid class and immediately reinvested in the side pocket class, pro rata to their stake. No cash changes hands.
- Freeze. From then on, ownership of the side pocket is fixed. Investors can keep redeeming from the liquid portfolio on the usual schedule, but the side pocket interest cannot be redeemed. New subscribers do not participate.
- Realization. When the asset is sold or written off, or in some funds when the manager judges that it can be valued reliably again, the side pocket shares are redeemed. Investors still in the fund have the proceeds reinvested in the liquid class. Investors who have already left receive cash.
Some funds let investors choose. Participation can be optional, and the investor usually has to opt in or out of all side pockets at once, as a single choice. Many funds also cap the total: caps typically run between 5% and 25% of the fund's or each investor's net assets, measured when the side pocket is created. A later fall in the liquid portfolio or a wave of redemptions can therefore push the side pocket above the cap without breaching the documents.
A fund of hedge funds can hold side pockets at one remove. One registered fund of hedge funds told its investors in 2014 that it would generally avoid underlying funds that would push its side pocket exposure above 5% of its net assets, and warned that it might be unable to exit an underlying fund fully while side pockets remained.
Fees charged on side-pocketed assets
Common fee terms for side-pocketed assets:
| Fee or cost | Common treatment | What it means for the investor |
|---|---|---|
| Management fee | Often charged on the lower of cost and fair value | A written-down asset costs less in fees. A written-up asset does not raise the fee above cost. |
| Incentive fee or allocation | Paid only when the investment is liquidated | No performance fee is paid on a paper gain that may never be realized. |
| High-water mark | Sometimes part of it moves into the side pocket with the asset | This favors the manager: the liquid portfolio's high-water mark falls, so incentive fees on it can resume sooner. |
| Fund expenses | Allocated using total balances, side pocket included | An investor who has redeemed from the liquid portfolio can owe expenses that are deducted from side pocket proceeds later. |
Some funds charge the management fee on the side pocket's fair value, so the fee rises with the manager's own estimate of the asset. In the Palisades and GLG cases described below, that link between the mark and the fee is what made overvaluation profitable.
When management fees are charged to side pocket investors, they gradually reduce those investors' ownership of the side pocket compared with investors who pay no fee, such as the manager's own capital. And an investor who has left the liquid fund has no cash balance left to pay their share of ongoing expenses, so the fund records a payable against their side pocket proceeds.
India's rules for mutual funds are stricter. The securities regulator, which has permitted segregated portfolios in debt mutual funds since December 2018, bars investment and advisory fees on the segregated portfolio and allows other expenses only when money is recovered. For the general fee structure of hedge funds, see our guide to hedge fund fees, high-water marks and hurdles.
How side pocket assets are valued
An asset goes into a side pocket because it has no reliable market price, so its value is an estimate made by the manager or a committee. Such holdings are Level 3 assets in fair value accounting: not quoted, and with a value that cannot readily be determined from outside data.
That estimate feeds three numbers at once. It sets the side pocket value on investor statements, it sets the management fee where the fee is charged on fair value, and it sets the assets under management the firm reports. A mark that is too high raises all three.
GLG Partners managed a side-pocket fund, GLG Emerging Markets (Special Assets) Fund, that held a 25% private equity stake in an emerging market coal mining company. From November 2008 to November 2010 the stake was carried at $425 million, although an outside valuation firm put its final valuation midpoint at $265 million, $160 million less than GLG's mark. GLG's policy required an independent pricing committee to value the position monthly, but the committee did not receive the relevant information in time. In December 2013 the firm and its former US holding company agreed to pay nearly $9 million, including $7.77 million in disgorged fees, without admitting or denying the findings.
Until the asset is sold, an investor holding a side pocket interest sees only the manager's number, which may not reflect the actual sale price upon realization.
Side pockets, gates and suspensions compared
Side pockets are one of several ways a fund can slow or restrict withdrawals. Most of the others restrict the whole fund, while a side pocket isolates specific assets.
| Tool | What it restricts | Who bears the illiquid assets | Typical terms |
|---|---|---|---|
| Lock-up | All redemptions for a set period after investing | All investors, pro rata | Six months to two years from subscription |
| Gate | The share of the fund or of an investor's stake that can leave on one redemption date | All investors, including new ones | 5% to 25% of net assets per date, or a rolling 25% per quarter per investor |
| Suspension | All redemptions, for as long as it lasts | All investors, including new ones | At the manager's or board's discretion under the documents |
| Holdback or slow-pay | The redeeming investor's share of illiquid assets only | Redeeming investors for their share, remaining investors for the rest | Paid out as the assets are sold, sometimes through a liquidating vehicle |
| Side pocket | Specific designated assets only | Only investors in the fund at designation | Capped at 5% to 25% of net assets, redeemed at realization |
Managers also combine the tools. A fund can side-pocket the positions it cannot value and gate redemptions from the rest of the portfolio at the same time. Our overview of multi-manager hedge funds shows how the most sought-after firms write long lock-ups and investor-level gates into their standard terms.
Side pockets in the 2008 crisis, the 2022 sanctions and the FTX collapse
2008 and 2009
Side pockets were in use before the crisis: the Palisades and Baystar cases described below involve side pockets from 2005 and 2006. In January 2009, as funds outside Switzerland were using side pockets to avoid suspending all redemptions, the Swiss regulator FINMA said it could approve side pockets for Swiss funds of hedge funds, subject to its prior approval and only in the interest of all investors.
Funds that imposed gates or side pockets during the crisis did not reduce their sales of illiquid stocks after restricting investors, and they underperformed a control group of funds without restrictions. After the crisis, fund families that had used them had more difficulty raising capital and were more likely to cut their fees.
Russia in 2022
When Russia invaded Ukraine in February 2022, sanctions and market closures left funds holding Russian securities they could neither trade nor value. Hedge funds with side pocket provisions could use them. Retail funds in the UK and the US had no such tool at the time.
The UK Financial Conduct Authority wrote rules allowing authorised retail funds to create side pocket unit classes for Russian, Belarusian and Ukrainian holdings that were sanctioned or could not be valued or traded. The rules took effect on July 11, 2022, and the FCA declined to extend side pockets to retail funds more broadly.
In the United States, the iShares MSCI Russia ETF had no such option. It suspended new share creations on March 1, 2022, its board voted to liquidate on June 15, and on August 3 the SEC granted it exemptive relief to suspend redemptions until the liquidation was complete.
Crypto funds and FTX
When the FTX exchange collapsed in November 2022, assets that crypto hedge funds had left on the exchange became claims in its bankruptcy. Multicoin Capital, which had 10% of its hedge fund's assets stuck on FTX, created a side pocket in November 2022 for the affected assets. It included funds withdrawn from FTX just before the collapse, which the FTX estate could try to claw back. The hedge fund lost 91.4% in 2022.
SEC rules and enforcement on side pockets
A private fund's side pocket terms are contractual and set by the fund's documents, since no SEC rule governs how a side pocket must run. The SEC polices them through the antifraud provisions of the Investment Advisers Act and through reporting on Form PF.
Reporting. Form PF asks advisers to report the percentage of each open-end private fund's net asset value that may be subjected to a suspension or a gate, and the percentage currently suspended or gated. Advisers with at least $1.5 billion in hedge fund assets must file a current report within 72 hours when a qualifying hedge fund cannot pay redemptions or suspends them for more than five consecutive business days. Side-pocketed positions count as positions of the fund in the form's asset reporting.
Registered funds. Section 22(e) of the Investment Company Act bars mutual funds and ETFs from postponing payment on a redemption for more than seven days after tender, except in narrow circumstances or by SEC order, which is why the Russia ETF above needed an order.
Enforcement. SEC cases involving side pockets have turned on inflated valuations and diverted proceeds:
- Palisades Master Fund, 2010
- The SEC alleged that two managers placed the fund's holdings in World Health Alternatives in a side pocket in 2005 and valued them in a way that contradicted their own undisclosed internal assessment, which inflated reported net asset values and their management fees.
- Baystar Capital II, 2011
- A side pocket investment became profitable in 2006, but the manager diverted more than $12 million of proceeds to other entities he controlled and sent investors statements showing no realized gains. He agreed to pay more than $14 million without admitting or denying the allegations.
- GLG Partners, 2013
- Overvaluation of the coal stake in its side-pocket fund, described above, produced $7.77 million in excess fees.
In December 2024 the SEC sued a Connecticut adviser, alleging that it had suspended withdrawals from its fund since November 2016 while buying small-cap stocks that its principal also owned, and had not obtained the annual audits its documents required.
Outside the United States, the EU's revised AIFM Directive of March 2024 defines side pockets as separating assets whose economic or legal features have changed significantly or become uncertain due to exceptional circumstances. Managers of open-ended alternative funds may activate them in exceptional circumstances and must notify their home regulator when they do.
Side pocket terms to check before investing
These questions belong in the redemption terms review of any hedge fund due diligence.
- Can existing holdings be moved into a side pocket? A manager who can designate an asset after the fact can, in effect, block part of every redemption in a downturn. A clear definition of what qualifies limits that power.
- What is the cap, and is it per fund or per investor? Typical caps run from 5% to 25% of net assets. A document with no cap leaves the size of the frozen portion to the manager.
- What is the management fee charged on? Cost, fair value, or the lower of the two. Fair value lets the manager's own estimate set the fee.
- When is the incentive fee paid, and what happens to the high-water mark? Realization-only incentive fees are standard. A high-water mark that moves into the side pocket with the asset favors the manager.
- Who values the side pocket, and how often? Look for an independent pricing committee with a documented process, and ask whether outside valuations are used. GLG had a committee on paper that did not receive the information it needed.
- Does the administrator see and report the side pocket? In the Baystar case the manager hid side pocket profits from the fund's third-party administrator. Investor statements should show side pocket holdings and any realizations separately.
- Is the fund audited every year, and who is the auditor? A missing audit was one of the allegations in the 2024 suspension case.
- What happens to expenses after a full redemption? Ask whether they accrue as a payable against side pocket proceeds, and for how long.
Our guide to what a hedge fund is covers the wider structure, and the minimums and investor tests that apply before anyone can invest at all. This article is general information, not investment advice.
Questions about side pockets
What is a side pocket in simple terms?
A side pocket is a separate account inside a hedge fund that holds an asset the manager cannot sell or value reliably, such as a stake in a private company or a claim in a bankruptcy. Each investor in the fund at that moment receives a share of it in proportion to their holding. That share cannot be redeemed until the asset is sold or written off, while the rest of the investment stays redeemable on the fund's normal terms.
How long can money stay in a side pocket?
Until the asset is sold or written off, or in some funds until the manager judges that it can be valued reliably again, which can take several years. The side pocket has no redemption date of its own. An investor who redeems everything else from the fund stays an investor in the side pocket for that whole period and receives the proceeds only when the position is realized.
Can mutual funds use side pockets?
Not in the United States without regulatory help. Section 22(e) of the Investment Company Act bars a registered fund from postponing redemption payments for more than seven days, except in limited cases or by SEC order. In 2022 the iShares MSCI Russia ETF needed an SEC order to suspend redemptions while it liquidated. India has allowed segregated portfolios in debt mutual funds after credit downgrades since December 2018, and the UK allowed side pockets from July 11, 2022 for retail funds holding Russian, Belarusian and Ukrainian assets that were sanctioned or could not be valued or traded.