Be Wary of Hedge Funds' Use of "Side Pockets"

The use of "side pockets" is growing, and already about 20% of hedge funds employ them. Many, but not all, hedge fund agreements limit the size of side pockets to 10% to 20% of fund assets.

The concern is that hedge fund investors unknowingly may be allowing their funds to invest in speculative or illiquid investments, or to conceal poorly performing investments with the use of side pockets.

The side pocket can be a dumping ground for private equity investments, venture capital, mezzanine financing, and, perhaps worse, publicly traded poor performers.

The result, under all such scenarios, is that any valuation will not account for such side-pocket investments. This creates the potential for more risk and more fraud.

Source: Investment Dealers' Digest Magazine and SourceMedia, Inc., and Wall Street Journal