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Tuesday, August 08, 2006

Side Pockets - Use or Abuse?

From Information Arbitrage

The issue of "side pockets: is a very thorny issue that is gaining increasing currency with investors and regulators alike. This issue was given some high-profile treatment recently in Wall Street Journal. From a macro perspective it shows the increasingly blurry divide between hedge funds and private equity; from a micro perspective side pockets have been used for years by hedge funds to address a wide range of issues, but the "hot button" application of the day is what I wrote about below.

But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

And if the industry doesn't take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they'd rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above.

I also went on to express my belief that hedge funds should be proactive in dealing with this issue by pooling assets based on an liquidity standard into separate accounts, for which they would receive compensation based upon their liquidity characteristics (liquid assets paid on a hedge fund/quarterly model with illiquid assets paid on a private equity/liquidation model). Otherwise, these matters would be addressed by somewhat less-friendly constituencies:

And if the industry doesn't take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they'd rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above. One way to possibly deal with this is to create a fund with two share classes - one which tracks the liquid assets (and therefore has a calculable NAV) and another which captures the illiquid assets (which does not have a readily calculable NAV). The liquid asset class could attract performance compensation in the same way hedge funds are paid today, which is generally quarterly. The illiquid asset class, however, could be treated much the way private equity compensation is handled today, based upon realization of the value of the illiquid investments. A manager could then report two NAVs, one for each share class. This would seem to restore the original intention of hedge fund compensation model, while providing for a better matching of performance generation and performance payment. This would also be a great PR move for the industry, proactively dealing with an issue before it becomes a PR nightmare.

Hedge fund managers are generally super smart and excellent asset allocators. But today's changed world calls for a new model - a fairer model, a more sensible model. Just as the most innovative managers have been pushing the edge of new and different asset classes, they should aggressively lead the charge in pushing best practices on this rapidly growing and influential industry.

Today's WSJ article highlighted the flip-side of how hedge fund should be using side pockets and segregation of illiquid and hard-to-value assets - namely, cherry picking - which will only serve to bring greater scrutiny to the industry:

An accurate value for these investments sometimes can be derived only when they are disposed of, so hedge funds often are slower to put up-to-date valuations on the accounts. Regulators say side pockets are appropriate for investments that are difficult to value or are illiquid, that is, hard to trade, noting that if a fund was forced to place an inappropriate value on these investments, it could penalize a fund's investors.

But side-pocket accounts often have more onerous terms for investors, such as limits on their ability to withdraw their money, terms that are put in place so a fund can avoid being forced to sell investments at a sizable loss if a number of investors suddenly want their money back.

Now, regulators are expressing some concern that hedge funds might be tempted to store investments with less rosy prospects in these accounts, enabling firms to make their returns look better.

The real issue here shouldn't be viewed as the delayed withdrawl issue, as long as the hedge funds are following the illiquid asset percentage outlined in their offering document (which they generally all do). The bigger issue on this score is that these assets should attract delayed compensation as well. The asymmetry between delayed withdrawl and current compensation just doesn't make sense, and in my view is not sustainable and will be modified - either voluntarily or by regulation - over time. This is a structural problem that requires changing conventional mores and practices.

The truly insidious issue here is that of cherry picking, where a hedge fund manager, regardless of the liquidity characteristics of the assets, will shift between the main fund and its side pockets in order to hype fund performance (and associated compensation). This is accomplished by either shunting off less succesful liquid investments into the side pockets or including hard-to-value but seemingly successful illiquid investments into the main fund. This is just wrong yet is sometime done. Just as with the rules governing the valuation of employee stock options, this is an area where there is simply too much latitude that will (and has) inevitably give(en) rise to abuse. Rules or practices will evolve to address this issue, with a clear and consistently applied framework for determining the following:

What is a liquid asset (and should be in the fund)? What is an illiquid asset (and should be in a side pocket)?
How should risks be quantified?
How should the valuations be performed?
How should performance be measured and communicated?
How should compensation be paid?
How should redemptions be handled?
This isn't just an issue of to-regulate-or-not-to-regulate - this is an issue of how much uncertainty investors are willing to bear. As investors in the hedge fund asset class become increasingly large, sophisticated and powerful (read: pensions and endowments), my sense is that they will not stand for this kind of gamesmanship and manipulation. The only question here is whether this issue is goverened by rules or practices - and if hedge funds don't get their act together and become proactive users of best practices in this area I am pretty sure which governance model will come to pass.

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