Hedge Funds’ Dirty Little Secret: Side-Pocket Pool

A number of hedge-fund firms are setting up separate accounts to hold certain harder-to-value investments. Now regulators and investors are becoming concerned about whether these accounts, known as "side pockets," are being handled properly and whether they might help some hedge funds to overstate performance.

As hedge funds turn to longer-term stock and debt investments, some are placing as much as 25% of their investments in these side accounts.

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.

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