While it is not unusual for a hedge fund to be organized for the purpose of purchasing distressed debt, the D.E. Shaw group (D.E. Shaw) is putting an interesting twist on this concept. It has been widely reported in the press that D.E. Shaw organized an in-house team in 2009, the D.E. Shaw Portfolio Acquisitions Unit, to evaluate purchases of illiquid assets from other hedge funds. In particular, the D.E. Shaw unit is looking at assets in other hedge funds’ side pockets. Generally, a side pocket is an account established by a hedge fund to hold assets that are less liquid than the remainder of the portfolio. See “Secondary Buyers of Private Equity Fund Interests are Looking at Assets in Hedge Fund Side Pockets
,” Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009). Such purchases can be a boon to both sides. Selling hedge funds can refocus on their more liquid portfolio, and purchasing hedge funds – especially those with longer lock-ups – can realize the long-term value in currently illiquid assets. However, such purchases also involve challenges. For example, investors in the selling hedge fund may allege that the side pocketed asset was undervalued for purposes of the sale, and based on such alleged undervaluation may bring claims against the selling manager for breach of fiduciary duty or material misrepresentations or omissions. For the purchasing hedge fund, such a purchase will involve considerable due diligence, including obtaining sufficient information to make an informed investment decision in light of what is often a matrix of confidentiality agreements. Similarly, only certain hedge funds are set up to hold side pocketed assets for long enough to realize value – and to avoid the same liquidity pressures that cause the selling hedge fund to sell. Depending on the characteristics of the purchased asset, the purchasing hedge fund would need a lock-up that in most cases could not be less than two years. This article highlights the potential and challenges involved in purchases by hedge funds of assets in the side pockets of other hedge funds. In particular, this article discusses: the mechanics of side pockets (including their implications for calculation of net asset value (NAV) and management and performance fees); fiduciary duty and securities law concerns inherent in purchases by hedge funds of illiquid assets from other hedge funds; the recent increase in distressed debt trading activity, both by hedge funds with a traditional competency in the area and newer entrants; valuation issues facing the selling hedge fund; valuation issues for the buyer; lock-up and liquidity prerequisites for the buyer; and the effect of such purchases on redeeming and non-redeeming investors in the selling fund.