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Side pockets (SPs) and designated investments (DIs) are tools that allow managers to hold illiquid or hard-to-value assets without disrupting liquidity for the rest of the portfolio. They’ve been around for decades, but questions about sizing, governance, and intent still come up, especially when investors see large allocations in certain strategies.
Is There a Standard Percentage for Side Pockets?
There is no universal rule. Side-pocket capacity is negotiated in the fund’s governing documents, typically the Private Placement Memorandum (PPM) or Limited Partnership Agreement (LPA). In practice:
Fund-Level Caps: Most hedge and hybrid funds include an aggregate cap, often in the 10–25% of NAV range. Lower for plain-vanilla long/short equity, higher for special situations or event-driven mandates.
Per-Position Limits: Some funds impose a 5–10% NAV cap per side-pocketed asset.
Additional Vehicles: Truly illiquid or concentrated opportunities often go into sidecars or co-investment vehicles, which have their own terms and caps.
Does Capital Move from LPs into Side Pockets?
Not in the way many assume. In an open-ended hedge fund, the manager designates an existing position as a side pocket. Investors already in the fund become pro-rata holders of that asset, and that slice becomes non-redeemable until realization. For hybrid or drawdown structures, managers may raise additional capital into a parallel vehicle, but that’s elective and separately documented.
Are Side Pockets Used to Boost Returns?
Properly governed, no. Side pockets are a liquidity and fairness mechanism, not a performance patch. Key protections include:
Incentive fees crystallize only on realization, often with separate high-water marks.
Post-2008 reforms tightened designation criteria, valuation oversight, and LP Advisory Committee (LPAC) involvement to prevent gaming optics.
Why Do Some Managers Have Larger Side-Pocket Capacity?
Strategies like distressed credit, litigation finance, and deep value often straddle public and private markets. A higher cap gives managers flexibility to pursue these without forcing fire sales during redemptions. The trade-offs: longer redemption tails, more complex reporting, and valuation scrutiny, which sophisticated LPs accept when they want access to these opportunities.
What Do LPs Typically Negotiate?
Clear caps (fund-level and per-position)
Objective designation criteria (e.g., trading halts, restructuring events)
Fee treatment (management fee on cost vs. fair value; carry only on realization)
Transparent reporting separating main fund and side-pocket performance
Redemption mechanics that prevent main-book liquidity being supported by illiquid assets
Bottom Line
Side pockets aren’t inherently good or bad, they’re a structural tool. The key is alignment and transparency. If you’re diligencing a fund, ask:
What are the caps?
How is designation triggered?
How are fees calculated?
Who oversees valuation?
How are performance and liquidity reported?
When these answers are clear, side pockets can be a feature, not a bug.