Side Pockets: A Hedge Fund Invention

A fund that holds both public equities and private companies sells as the best of both worlds. It is, right up until an investor tries to leave. File a redemption notice and part of the money arrives in weeks. The rest stays invested, in the investor's name, until every private company is sold.

Why it matters: the redeeming investor keeps paying a management fee on capital they have already asked for back. On the position below that is $800,000 a year, and nobody can tell them when it stops.

The structure invites it. An open-ended fund lets the manager admit investors whenever the LPA permits, as long as they qualify as accredited. Managers hunt for one anchor investor with the deepest pocket, because once that name is committed the rest of the book sells itself. Capital therefore arrives and leaves while the fund is running.

The setup:

• The fund runs $5,000,000,000 of AUM.

• The book is roughly 60% public equities and 40% private companies.

• One investor holds $100,000,000, or 2.00% of the fund. They file to redeem in full.

A redemption request arrives as one number. It settles as two.

The $60,000,000 is a scheduling problem. The manager works the public positions down over time and wires the proceeds. Slow, but mechanical.

The $40,000,000 is not. Selling private positions on a redemption clock means selling at a discount, which is why the LPA generally forbids it.

So the fund does something stranger. It moves the redeeming investor into their own share class and leaves the private positions there until each company is realized. Capital comes back with whatever gain or loss the sale produces. That is a side pocket.

The process is spelled out in the LPA, often in detail. Investors are still shocked by it, because reading a redemption clause and living through one are different things.

The investor has redeemed. Forty percent of their capital is still at work. What the LPA answers next is what they pay while they wait.

The bill does not stop at redemption. A side pocket is still a position, so it is still billed like one.

Between the lines: the pocket also dilutes. When the fund puts fresh money into a company the investor is pocketed in, the redeeming investor does not fund the follow-on. Their share of that company shrinks. Performance has to be tracked position by position for one investor, not fund-wide.

Then it branches. Every redemption creates another class with its own private book, its own fee base, and its own dilution history.

That is the layer the fund administrator lives in. Two redemptions and a follow-on turn one NAV calculation into a tree, and keeping the tree correct becomes a full-time job.

The bottom line: the side pocket protects the fund from a forced sale and the remaining investors from the discount. It does not release the redeeming investor. It leaves them holding equity risk, no exit date, and a running fee, on money they have already asked to withdraw.

I operationalized one of these for a hedge fund when few Norwegian managers had run the mechanism in practice. One NAV becomes many, and it happens quickly.