Hedge Fund ‘Side Pockets’

The SEC is targeting valuations of illiquid securities

If your hedge fund already has side pockets or can add them, be careful about what investments you place in them and how you value those investments.

The SEC has made side pockets a priority investigative issue and, in October 2010, its Asset Management Unit charged two Georgia-based hedge funds with fraud for overvaluing side pocket investments and thereby deceiving their investors about fund performance and charging them inflated management fees.

The Asset Management Unit is expected to focus on whether a fund manager’s side pocket practices are consistent with its PPM disclosure, particularly in regard to the criteria used to deposit investments in side pockets and the methodology used to value them.

Managers could be faced with discomfiting questions from SEC examiners in cases where side pocket investments are later sold for lower prices than their earlier valuations.

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