You can find side pockets on backpacks and handbags, but in the financial world, side pockets aim to protect investors from illiquidity risk.
Technically, side pockets are a “liquidity management tool” involving the “segregation of assets,” per Luxembourg’s financial regulator, the CSSF. They can be planned or can be a response to a crisis.
They are commonly used by hedge funds “to segregate riskier or illiquid assets from more liquid investments,” per Investopedia.
Sometimes side pockets are created “when there’s an emergency that the fund manager can’t control,” said the UK regulator FCA, “such as the impact of the war in Ukraine.” International sanctions against Russia, following its full-scale invasion of Ukraine, and disruptions to Ukraine’s economy meant that many assets could not be bought or sold, or valued accurately. Often that means that fund managers need to suspend subscriptions (selling fund shares to investors) and redemptions (returning cash to investors who want to leave the fund). By separating out certain assets, the main fund can continue to function normally.
New shares or new subfunds
The rules on creating side pockets are not always clear. Both the CSSF and FCA say it’s up to each fund manager to decide if and when to use side pockets and how to proceed (although regulators will monitor the process). Fund firms can create new share classes to distribute to investors or split the troubled assets into new subfunds. On the other hand, sometimes fund managers will simply dispose of assets as best they can.
Investopedia noted: “Usually, once a position enters a side pocket account, only the current participants in the [fund] are entitled to a share of it. Future investors will not receive a share of the proceeds should the asset’s returns become realised.” That means new investors are not exposed to the risk, but do not benefit from any potential upside. Conversely, existing investors remain partially exposed, but will gain from any future profit generated from the assets.