The past two years have witnessed two related but opposing trends in the hedge fund world: an increasing proportion of assets placed in side pocket accounts, and an unprecedented volume of redemption requests. The trends are related in that as the volume of redemption requests or anticipated requests increased, side pockets were one of the tools employed by managers to stem the outflow of capital. See “Hedge Fund Managers Using Special Purpose Vehicles to Minimize Adverse Effects of Redemptions on Long-Term Investors
,” Hedge Fund Law Report, Vol. 2, No. 15 (Apr. 16, 2009). The trends are opposing in that as more assets were placed in side pockets, fewer assets were available to pay redemptions in cash. See “Can a Hedge Fund Make Redemption Payments ‘In Kind’ by way of the Issue of ‘Participation Interests’ in its own Illiquid Assets, and What is the Status of a Redeeming Investor who has not Received any Payment at All?
,” Hedge Fund Law Report, Vol. 2, No. 13 (Apr. 2, 2009). Moreover, to the extent redemptions were paid in cash, the remaining portfolio became less liquid – to the dismay of many investors who invested with certain liquidity assumptions. In an effort to reconcile these opposing trends – to increase the overall liquidity of a portfolio, which in turn would enhance the ability (if not the desire) to pay redemptions in cash, which in turn (presumably) could help slow the rate of redemption requests – hedge fund managers have been looking for ways to liquidate assets in side pockets. But as credit markets have remained more or less frozen, buyers of such assets have been few and far between. Some investors and managers have turned to secondary markets to transfer exposure to side pocketed assets to investors with more “patient capital.” However, secondary markets can be an imperfect remedy for various reasons, including the substantial discount at which hedge fund interests often trade in secondary transactions, as well as valuation and confidentiality concerns. See “Valuation and Confidentiality Concerns in Secondary Market Trading of Hedge Fund Interests
,” Hedge Fund Law Report, Vol. 1, No. 27 (Dec. 9, 2008); “Hedge Fund Managers and Investors Turning to Dutch Auctions as an Alternative to Secondary Markets for Hedge Fund Interests
,” Hedge Fund Law Report, Vol. 2, No. 10 (Mar. 11, 2009). However, there may be another option for hedge fund managers looking to liquidate side pocketed assets. In at least a few recent deals, firms that have historically specialized in purchasing secondary interests in private equity funds have purchased assets in hedge fund side pockets. Such investors are structured for longer-term investments – they generally have capital locked up for at least three years, often longer – and thus are better situated to realize long term value in currently illiquid assets than are many of the hedge fund investors with side pocket exposure. Our analysis of this trend includes discussions relating to: illiquid assets; the mechanics of side pockets; the operations of and participants in the secondary market for purchasing side pocketed assets; the opportunity identified by buyers of such assets; and the ongoing relevance and practicability of side pockets.