72% of hedge funds now use side pockets to hold illiquid assets, according to Preqin's latest alternative assets survey. Managers increasingly view side pockets as paths to opportunities outside core mandates—including private equity, real estate, derivatives, and cryptocurrencies—while maintaining main fund liquidity and strategy discipline. Effective side pocket management enhances transparency, reduces illiquid asset impact on main funds, and provides long-term investment flexibility.
Understanding Side Pocket Structures
Side pockets are segregated accounts within hedge funds that hold illiquid or hard-to-value investments, typically with restricted redemption rights until the investments are realized or deemed realized. This structure prevents redeeming investors from forcing premature liquidation of illiquid positions while protecting remaining investors from bearing disproportionate illiquid exposure.
The mechanics are straightforward but operationally significant. When a fund side-pockets an investment, it creates a separate class or series of interests specific to that asset. Existing investors receive pro-rata allocations to the side pocket based on their main fund ownership at creation time. New investors subscribing after side pocket creation receive only main fund interests without side pocket participation.
Why Side Pocket Usage Has Grown
The 72% adoption rate reflects multiple converging trends. Market disruptions during 2020-2022 created illiquid positions across asset classes—public equity positions in halted securities, private investments requiring extended hold periods, distressed credit requiring workouts. Side pockets provided mechanisms for isolating these positions without disrupting main fund operations.
Beyond crisis management, managers increasingly view side pockets strategically as vehicles for pursuing attractive opportunities outside core mandates. A long-short equity fund might side-pocket private equity investments in compelling pre-IPO companies. A multi-strategy fund might segregate cryptocurrency positions or special situation investments requiring multi-year hold periods.
Operational Advantages for Fund Managers
Properly implemented side pockets deliver multiple operational and strategic benefits that justify their administrative complexity.
Main Fund Liquidity Preservation
The primary operational advantage of side pockets is preserving main fund liquidity. By segregating illiquid investments, the net asset value of the main fund reflects only liquid assets, ensuring redemption requests or market fluctuations don't distort valuation.
This separation prevents forced selling of illiquid positions to meet redemptions—a scenario that frequently realizes losses and damages remaining investors. When investors redeem from main funds, they receive their proportionate share of liquid assets without affecting side-pocketed positions held for optimal exit timing.
Preventing Dilution and Free-Rider Problems
Side pockets prevent the free-rider problem where redeeming investors benefit from work the manager performs on illiquid positions after redemption. Without side pockets, investors redeeming before illiquid position exits receive redemption proceeds based on potentially conservative marks, while remaining investors bear the risk and receive the benefit of eventual exits.
Similarly, investors subscribing to funds holding illiquid assets benefit from side pocket structures. New investors aren't diluted by inheriting pro-rata shares of illiquid positions they didn't underwrite. Their capital deploys into liquid strategies they evaluated, while existing investors maintain full exposure to legacy illiquid investments.
Enhanced Risk Transparency
Clear separation within fund structures allows investors to choose their risk and liquidity level more precisely. Some investors seek exposure to illiquid investments due to higher return potential, while others prefer pure liquid strategies. Side pockets enable funds to accommodate both preferences simultaneously.
This transparency extends to reporting. Investors receive separate performance attribution for main fund and side pocket positions, understanding precisely how each contributes to overall returns. This granularity supports more informed investment decisions and reduces surprises when illiquid positions eventually realize.
Side Pocket Administration Complexity
While side pockets deliver clear benefits, they create administrative complexity that funds must manage effectively.
Separate Accounting and Valuation
Each side pocket requires separate books and records, distinct NAV calculations, and independent valuation processes. Administrators must track which investors hold side pocket interests, calculate allocations of income and expenses between main fund and side pockets, and maintain complete audit trails for both.
Valuation becomes particularly complex when side-pocketed assets lack observable market prices. Private investments, distressed credit positions, or special situations require sophisticated valuation approaches—often including third-party appraisals or valuation specialist input—that increase costs and time requirements.
Investor Communication and Reporting
Side pockets require enhanced investor communications explaining their creation rationale, valuation methodologies, expected holding periods, and potential exit scenarios. Investors unfamiliar with side pocket structures may question why positions were segregated or how valuations are determined.
Reporting must clearly distinguish main fund and side pocket performance, showing both separately and on a combined basis. Capital statements track investor ownership in multiple classes simultaneously—main fund shares plus allocations across potentially multiple side pockets created at different times.
Distribution Processing
When side-pocketed investments eventually exit, administrators must calculate distributions to the specific investor class holding that side pocket. These distributions occur outside normal redemption cycles and may go to investors who have otherwise fully redeemed from main funds but retain side pocket interests.
This creates ongoing administrative obligations for positions that may take years to realize. Funds must maintain accurate investor records and contact information for former investors who retain only side pocket interests, process distributions when exits occur, and handle tax reporting for these irregular payment events.
Regulatory Considerations
Side pocket usage attracts regulatory scrutiny, particularly around valuation practices, fee calculations, and investor disclosure.
SEC Focus on Fair Treatment
The SEC has toughened scrutiny on side pockets, focusing on whether managers use them appropriately to protect all investors or opportunistically to favor certain investor classes. Examinations assess whether side pocket creation criteria are objective and consistently applied, whether valuations are supportable and independent, and whether fee calculations treat all investors equitably.
Managers must document clear policies governing when side pockets may be created, what types of investments qualify for side pocket treatment, and how decisions balance various investor interests. Ad hoc or inconsistent side pocket usage raises concerns about preferential treatment or conflicts of interest.
European Regulatory Framework
European regulators have established specific frameworks for UCITS side pockets, particularly relevant during COVID-19 market disruptions. These rules specify permissible circumstances for side pocket creation, maximum durations, governance requirements, and investor disclosure obligations.
UCITS side pockets must receive regulatory approval before creation and operate under strict limitations—typically allowing use only for truly exceptional market conditions rather than routine illiquid position management. This creates higher bars for usage compared to U.S. hedge fund practices.
Fee Treatment Complexity
Management fee and performance fee treatment of side-pocketed assets requires careful consideration. Should management fees continue accruing on side-pocketed positions during potentially multi-year holding periods? Should performance fees calculate separately for side pockets or integrate with main fund performance?
Common approaches include suspending management fees on side-pocketed assets until realization, calculating performance fees on side pockets only upon exit, or treating side pockets as separate accounts with distinct fee arrangements. The chosen approach must be disclosed clearly and applied consistently.
Technology Solutions for Side Pocket Administration
Modern fund administration platforms incorporate specialized capabilities for managing side pocket complexity efficiently.
Multi-Class Accounting Systems
Platforms supporting multiple share classes or series within single fund structures enable side pocket administration without maintaining completely separate fund entities. These systems track investor ownership across classes, allocate income and expenses appropriately, and generate class-specific NAVs automatically.
This multi-class capability extends to reporting. Automated systems generate investor statements showing both main fund and side pocket positions, calculate combined performance metrics, and maintain historical records as side pockets are created and eventually dissolved.
Workflow Automation for Creation and Dissolution
Side pocket creation involves numerous operational steps—board approvals, investor notifications, system setup, opening balances, and regulatory filings. Automated workflows ensure these steps complete in proper sequence with appropriate approvals and documentation.
Similarly, side pocket dissolution when investments realize requires systematic processing—calculating final valuations, determining distributions to the specific investor class, processing payments, and closing accounting records. Workflow automation ensures consistency and completeness across these complex processes.
Best Practices for Effective Side Pocket Management
Successful side pocket programs balance operational flexibility with investor protection and regulatory compliance.
Clear Governance Frameworks
Establish and document objective criteria for when side pockets may be used. These policies should specify illiquidity thresholds, valuation uncertainty parameters, or strategic rationale that justify side pocket treatment. Consistent application of documented policies demonstrates fair treatment and reduces regulatory risk.
Independent Valuation Processes
Side-pocketed assets should receive independent valuation oversight—whether through third-party appraisers, valuation specialists, or independent board committees. This independence provides credibility to valuations that may significantly affect investor returns and reduces conflicts of interest.
Enhanced Investor Communication
Proactive communication prevents misunderstandings and maintains investor confidence. When creating side pockets, explain the rationale clearly, describe expected timelines for realization, outline valuation approaches, and specify how investors can track positions. Regular updates on side-pocketed investments—even when no material developments occur—demonstrate ongoing attention and transparency.
Key Takeaways
- • 72% of hedge funds use side pockets for illiquid assets, with managers increasingly viewing them strategically for opportunities outside core mandates—private equity, real estate, derivatives, and cryptocurrencies—while maintaining main fund liquidity.
- • Side pockets preserve main fund NAV accuracy by segregating illiquid investments, preventing forced selling to meet redemptions and ensuring redemption requests don't distort valuations based on liquid asset portfolios.
- • Proper side pocket structures prevent free-rider problems where redeeming investors benefit from manager work on illiquid positions after redemption, while new investors avoid inheriting pro-rata shares of legacy illiquid investments they didn't underwrite.
- • SEC scrutiny intensified on side pocket usage, examining whether creation criteria are objective and consistently applied, valuations are supportable and independent, and fee calculations treat all investor classes equitably without preferential treatment.
- • Each side pocket requires separate accounting, distinct NAV calculations, independent valuation processes, and ongoing administrative obligations that may extend years as illiquid positions realize over extended periods.
- • Multi-class accounting systems enable side pocket administration without separate fund entities, automatically tracking investor ownership across classes, allocating income appropriately, and generating class-specific NAVs and investor statements.
Manage side pocket complexity with specialized fund administration technology. Polibit's platform supports multi-class structures, automated valuation workflows, and separate performance tracking—delivering the transparency and operational precision side pocket management demands. Explore Fund Administration Features or Schedule a Demo to see how technology simplifies illiquid asset segregation.
Sources
• Preqin (2025). Alternative Assets Survey - 72% of hedge funds now use side pockets to hold illiquid assets
• The Hedge Fund Journal (2025). Hedge Fund Side Pockets on the Rise - Managers view side pockets as paths to PE, real estate, derivatives, and crypto opportunities
• Richey May (2025). Exploring the Benefits of Side Pockets in Funds - NAV reflects only liquid assets, ensuring redemptions don't distort valuation
• Investment Law Group (2025). SEC Toughens Up on Side Pockets - Intensified scrutiny on valuation practices and investor fair treatment
• SSC Technologies (2025). Overcoming Operational Complexities of Side Pockets - Separate accounting, valuation, and reporting requirements