The term "Side Pocket" refers to a portion of the hedge fund that is segregated from the remainder of the assets for certain illiquid investments. These illiquid investments are hard to value, as much of the investments are level 3 assets, which do not even have a comparable security/ assets that are priced by market forces. Hedge Funds uses their own internal models to value them (which can be biased). The profits and losses derived from a side pocket investment are allocated solely to those investors that are in the fund at the time such investment is made. The capital related to such investment is not available for withdrawal until such investments are realized or otherwise become marketable securities. Typically about 10 to 15 percent of a fund may be reserved for side-pocket allocation, although there have been instances of larger side-pocket pools.
On the larger scale, there is potential for excessive leverage. For example- a subsidiary of Hedge Fund (say in a business of distressed lending) may keep on transferring its riskier positions into side pockets to free up and raise more capital from its parent Hedge Fund for fresh investments. This is called leverage.
Excessive concentration of positions, the dependence of valuations upon complex proprietary models, and high leverage are some issues that raise concerns over side-pockets. Hedge funds say side pockets are necessary to bundle & classify a similar type of investments because different investors have a different investment horizon & objectives.
