Hflr 0211 - Hedge funds structuring

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www.hflawreport.com Volume 4, Number 4 February 3, 2011

Side Pockets
How Can Liquid Hedge Funds Be Structured to Accommodate Investments in Illiquid Assets?
By Philippe Simoens, Weaver

During the past decade, an increasing volume of hedge fund fund structuring and taxation; characteristics and taxation
dollars has poured into traditional liquid strategies. As a of marketable securities versus private equity; and structures
result, market inefficiencies have narrowed or vanished, and employed by liquid funds to accommodate illiquid assets
opportunities for arbitrage – and the alpha it can generate (including side pockets, lock-ups, gates and redemption
– have grown fewer and farther between. In response, some suspensions). The article concludes with thoughts on
hedge fund managers that traditionally focused on liquid structuring for managers who traditionally have focused on
strategies started investing at least part of their funds’ capital liquid strategies, but who are exploring illiquid opportunities.
in private equity and other illiquid securities and assets.
However, using liquid fund vehicles to invest in illiquid assets Traditional Liquid Fund Structures and Taxation
has presented a variety of problems, including those relating
Domestic hedge funds typically are structured as limited
to: taxation, liquidity, valuation, manager compensation,
partnerships. The manager of the fund is often the general
strategy drift, due diligence, expectations regarding returns
partner of the limited partnership, and fund investors are
and regulatory scrutiny. While there has been considerable
limited partners in the partnership. In a basic fund structure,
discussion regarding the convergence of hedge funds and
a single domestic limited partnership will collect capital from
private equity funds, the experience and aftermath of
investors and the manager will invest funds according to the
the credit crisis indicate that the convergence discussion
fund’s strategy. See Table 1.
should be more refined. Convergence at the fund level is
problematic because illiquids do not fit naturally into a liquid
fund. Convergence at the manager level – for example,
the same manager managing both private equity funds and
hedge funds – is marginally more palatable, but by and large,
institutional investors have demonstrated a preference for
managers who stick to their knitting.

This article addresses some of the reasons why illiquid assets
present problems when housed in liquid funds – even liquid
funds purportedly structured to accommodate illiquid
investments via mechanisms such as side pockets. In the
course of doing so, this article explains traditional liquid Table 1

©2011 The Hedge Fund Law Report. All rights reserved.

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More complex fund structures achieve scale and leverage via disparate track records (because the performance of the master
pooling arrangements. So-called master-feeder structures pool fund flows through to the feeders); and creating a larger asset
funds from onshore and offshore feeder funds into a master base (by pooling the funds of both feeders in a single master),
fund, which is the main trading entity. See Table 2. which can help mitigate counterparty risk concerns and can
render the master fund eligible for certain transactions for
which the feeders individually may not be eligible.

Various types of income can subject the offshore feeder to
U.S. taxation. First, U.S. source dividend income paid or
allocated to the offshore feeder generally is subject to U.S. tax
withholding at a rate of 30 percent. Moreover, many of the
jurisdictions in which offshore feeders typically are established
do not have treaties with the U.S. that would reduce that 30
Table 2 percent withholding rate. In addition, any income earned
by the offshore feeder and construed to be derived from a
In a master-feeder structure, gains and losses realized by the U.S. trade or business would be subject to U.S. income tax at
master fund are allocated to the various feeder funds. Those graduated rates. Also, such “trade or business” income may be
gains and losses in turn are allocated to the investors in the subject to U.S. branch profits tax, also at a rate of 30 percent.
feeder funds. In sum, much of the income earned by an offshore feeder
from a U.S. trade or business would be taxed at a combined
The domestic feeder fund in a master-feeder structure is rate of 55 percent. This punitive tax rate may apply, for
usually organized as a limited partnership; most foreign feeder
example, to investments by non-U.S. persons in certain U.S.
funds in such structures are organized in a low tax jurisdiction
real estate and certain U.S. source debt. See “Implications of
and treated as corporations for U.S. tax purposes; and
Recent IRS Memorandum on Loan Origination Activities
most master funds are organized as corporations in low tax
for Offshore Hedge Funds that Invest in U.S. Debt,” The
jurisdictions, but “check the box” for partnership treatment
Hedge Funds Law Report, Vol. 2, No. 41 (Oct. 15, 2009);
for U.S. tax purposes. This structure enables flow-through tax
“IRS Rules that Long Position in a Swap Referencing a
treatment for U.S. taxable investors in the domestic feeder;
avoids passive foreign investment company tax issues; and Broad-Based US Real Property Index is Not a US Real

“blocks” unrelated business taxable income for U.S. tax- Property Interest for FIRPTA Purposes,” The Hedge Funds
exempt investors in the offshore feeder. In addition, a master Law Report, Vol. 1, No. 15 (Jul. 8, 2008). However, in
feeder structure offers practical advantages, such as: executing certain circumstances, non-U.S. investors may use a debt
all trades in a single vehicle and avoiding difficult allocation holding structure, which may enable them to benefit from the
questions; providing a single derivatives counterparty; avoiding U.S. source interest income tax exemption regime.


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Characteristics and Taxation of Marketable Investments by Liquid Hedge Funds in Illiquid Assets
Securities versus Private Equity
Despite the differing characteristics detailed in Table 3 and
Marketable securities and private equity and similar illiquid the differing tax consequences detailed in Table 4, over the
assets have different features and characteristics. Table 3 past decade, liquid hedge funds collectively have increased
illustrates various characteristics of marketable securities their stake in private equity and other illiquid assets. Liquid
versus private equity. Various of these characteristics are hedge funds have been able to do so in cases where their
difficult to reconcile within a single liquid hedge fund. governing documents include mechanisms enabling them to
invest a discrete percentage of assets in illiquid investments.
Those mechanisms prominently include side pockets, but also
include gates, lock-ups, and redemption suspensions.

Side Pockets

Side pockets generally are segregated accounts into which a
manager of an otherwise reasonably liquid hedge fund can
place an illiquid investment representing, as of the date of
investment, a designated percentage of net asset value. See
“Secondary Buyers of Private Equity Fund Interests are
Looking at Assets in Hedge Fund Side Pockets,” The
Hedge Fund Law Report, Vol. 2, No. 28 (Jul. 16, 2009).
Table 3
Side pockets generally can be used in two circumstances.
First, an asset can be purchased by a hedge fund with the
Table 4 contrasts various tax features of marketable securities
intent at the time of investment of placing the asset in a side
versus private equity, based on investor type.
pocket. Second, assets can be transferred to a side pocket in
order to prevent redemptions. While the line between these
two uses is sometimes blurry, the former use is significantly
more palatable to investors than the latter; and in the latter
incarnation, side pockets are merely one name used to refer
to a group of vehicles designed to retain assets and prevent
redemptions, often contrary to the expressed preferences
of investors. See “Steel Partners’ Restructuring and
Redemption Plan: Precedent or Anomaly?,” The Hedge
Fund Law Report, Vol. 2, No. 34 (Aug. 27, 2009).
Table 4


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The SEC has expressed concern regarding the use by hedge A less frequently cited rationale is to protect a run on the
fund managers of side pockets. In particular, the SEC has bank and an unraveling of the fund and management
evidenced that concern by bringing a civil fraud action against business. This latter, manager-perspective rationale appears
a hedge fund manager that allegedly used a “side pocket” to to run contrary to the creative destruction ethos of the hedge
misrepresent the value of its funds to investors. See “SEC fund industry, engendered significant apprehension among
Brings Civil Securities Fraud Action Against Principals of investors during the credit crisis and caused a rethinking
Hedge Fund Palisades Master Fund, Alleging Fraud, Self- and renegotiation of hedge fund terms post-crisis. See, e.g.,
Dealing, Misuse of Fund Assets and Use of a ‘Side Pocket’ to “CalPERS Special Review Foreshadows Seismic Shift in
Misrepresent the Fund’s Value to Its Investors,” The Hedge Business Arrangements among Public Pension Funds,
Fund Law Report, Vol. 3, No. 42 (Oct. 29, 2010). Hedge Fund Managers and Placement Agents,” The Hedge
Fund Report, Vol. 4, No. 1 (Jan. 7, 2011); “Single Investor
Gates Hedge Funds Offer the Benefits of Managed Accounts and
Additional Tax and Other Advantages for Hedge Fund
Generally, gates are mechanisms that limit the percentage
Managers and Investors,” The Hedge Fund Report, Vol. 3,
of net assets of a hedge fund that may be paid out in
redemptions on any given redemption date. Gates may No. 16 (Apr. 23, 2010); “How Can Hedge Fund Managers

be broadly grouped into two categories: fund-level gates Structure Managed Accounts to Remain Outside the

and investor-level gates. (A third category – “hybrid gates” Purview of the Amended Custody Rule’s Surprise

– will be discussed in a forthcoming issue of The Hedge Examination Requirement?,” The Hedge Fund Report, Vol.
Fund Law Report.) Generally, a fund-level gate may be 3, No. 5 (Feb. 4, 2010).
triggered (usually in the manager’s discretion) if the aggregate
redemption requests on any redemption date exceed a certain Lock-Ups
percentage of the hedge fund’s net assets, usually between A lock-up generally refers to the period following investments
10 and 25 percent. Use of a gate permits the manager to
during which an investor may not redeem from the hedge
reduce aggregate redemption requests pro rata such that
fund. Following the lock-up period, investors generally may
the total redemptions on that redemption date equal the
redeem periodically. See “Soft Lock-Ups Help Hedge Fund
gate threshold, e.g., that 10 to 25 percent. To the extent
Managers Reconcile the Goals of Stable Capital and Investor
redemptions exceed that threshold, they are carried forward to
Liquidity,” The Hedge Fund Report, Vol. 3, No. 45 (Nov. 19,
the next scheduled redemption date.
2010).

Investor-level gates operate similarly, but the relevant
Redemption Suspensions
thresholds are measured per investor capital account rather
than fund-wide. In either case, the most frequently cited Hedge fund documents generally provide that the manager
rationale for the use of gates is to protect remaining investors may suspend redemptions in designated circumstances. An
from winding up with a less liquid or lower quality portfolio. interesting recurring issue arises when an investor submits a


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redemption notice, the redemption notice expires, then the can give rise to such trade or business taxation. The most
manager suspends redemptions. In such a case, especially notable example is real estate. Offshore hedge funds that
for offshore funds, does the investor become a creditor of invest in U.S. real estate are subject to a level of taxation that
the fund with the power to petition for a winding up of the in all but the rosiest of scenarios can eviscerate the returns on
fund? A recent judgment of the Judicial Committee of the investment. While it may be possible to circumvent some of
Privy Council in Culross Global SPC Limited v Strategic these adverse tax consequences via derivatives, this tax regime
Turnaround Master Partnership Limited addressed this has dramatically diminished investment by offshore funds in
question, and provided helpful and authoritative guidance U.S. real estate.
about how provisions in a hedge fund’s governing documents
addressing redemptions and suspensions of redemptions Liquidity
should be interpreted. The judgment also provided guidance
on how to determine which of the various documents One of the more problematic issues presented by illiquid
constituting the investment agreement between a fund and assets in liquid funds is the liquidity mismatch. That is,
its investor should take priority if the documents contain investors are often promised monthly, quarterly or annual
inconsistent provisions. See “Strategic Turnaround liquidity, but illiquid assets require years for the realization
Judgment Provides Welcome Guidance for the Hedge of investment goals. While the mechanisms described
Fund Industry on the Suspension of Redemptions,” The above – side pockets, gates and the like – give managers the
Hedge Fund Report, Vol. 4, No. 3 (Jan. 21, 2011). contractual authority to manage redemptions in the interest
of realizing long-term value in illiquids, they often cannot
Challenges Posed by Illiquid Investments in mitigate the practical mismatch of expectations between
Liquid Funds managers of funds that are primarily liquid, and investors
who have expectations that the majority of their assets will be
Even in the presence of the foregoing mechanisms used
predominantly liquid. See “How Can Hedge Fund of Funds
individually or jointly to accommodate illiquid investments
Managers Manage a ‘Liquidity Mismatch’ Between Their
in liquid funds, such investments still are fraught with
investment and operational challenges. Those challenges, Funds and Underlying Hedge Funds?,” The Hedge Fund

as enumerated above, relate to taxation, liquidity, valuation, Law Report, Vol. 2, No. 40 (Oct. 7, 2009).
manager compensation, strategy drift, due diligence,
expectations regarding returns and regulatory scrutiny. Each Valuation
of these concerns is described in more detail below. The valuation problem here is easy to identify and hard
to remedy: many assets in liquid funds are comparatively
Taxation
easy to value because they are traded in liquid markets with
As discussed above, offshore funds that are construed as discoverable prices. By contrast, illiquid assets are hard to
engaged in a U.S. trade or business may be subject to punitive value because there are few or no bids for them. In such
taxation. Investments by liquid hedge funds in illiquid assets circumstances, valuation is often vested in the discretion


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of the manager, and from time to time, such discretion and the value of the liquid fund decreases, the proportion of
is exercised (or allegedly exercised) in a manner that is net assets comprised by assets in the side pocket may increase
arguably inconsistent with the interests of investors. See, to a percentage well beyond the percentage of net assets
e.g., “SEC and Connecticut Banking Commissioner Bring comprised by such assets at the time of purchase. In this
Civil Fraud Charges Against Stephen M. Hicks and the manner, an investor who bought into a liquid fund may wind
Southridge Hedge Fund Investment Advisers He Controls, up holding a fund that is primarily comprised of illiquid assets
Claiming that They Defrauded Investors by Failing to – especially if other investors redeem from the liquid pool
Follow Stated Investment Policies, Overstating the Fund’s or are granted preferential liquidity and redemption rights.
Asset Values and Misappropriating Fund Property,” The See “To What Extent is a Hedge Fund Bound, Legally
Hedge Fund Law Report, Vol. 3, No. 43 (Nov. 5, 2010). and Practically, by its Strategy as Stated in its Governing
Documents and at Marketing Meetings?,” The Hedge Fund
Law Report, Vol. 2, No. 49 (Dec. 10, 2009).
Manager Compensation
Hedge fund managers traditionally have been compensated Due Diligence
by collecting 2 percent of net assets under management as
a management fee, and 20 percent of fund gains annually From an investment team and operational perspective,
as an incentive allocation. Private equity managers, on the many hedge fund managers with a competency in liquid
other hand, traditionally have been compensated through a investing are not set up, in terms of personnel and process,
“waterfall” that provides for incentive-based compensation as to adequately evaluate investments in illiquid assets. While
distributions are made, for example: (1) a full return of capital certain aspects of investing in, for example, public equity and
called and not yet returned; (2) a preferred return to investors, private equity are similar, in many ways, the two categories
usually of 8 or 7 percent; (3) a general partner “catch up”; and of investing are very different disciplines with very different
(4) an 80/20 split between investors and the general partner skill sets. A good public equity investor is not necessarily a
or manager. While hybrid funds have sought to combine good private equity investor, and vice versa. On talent in the
the typical hedge fund “2 and 20” structure and the private hedge fund industry generally, see The Hedge Fund Law
equity “waterfall” structure, doing so involves considerable Report’s recent three-part series on movement of talent from
legal, accounting and operational legwork, and the level of proprietary trading desks to hedge fund managers.
complexity that is inconsistent with the current investor taste
for simplicity. Expectations Regarding Returns

Similar to the foregoing point, managers with a traditional
Strategy Drift
competency in liquid investing may not be ideally situated
Most side pocket provisions in hedge fund documents to predict the timing and level of fund returns from illiquid
are drafted to limit the amount of fund assets that may assets. Faulty predictions in this regard may lead to charges
be allocated to a side pocket as of the time of investment. from investors or regulators of misrepresentation, and, at
However, especially if assets in side pockets are carried at cost worst, to claims of breach of fiduciary duty.


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Regulatory Scrutiny private equity fund managers of discrete investment skill sets
and teams, see “Key Legal Considerations in Connection
As indicated, the SEC and other regulators have brought
with the Movement of Talent from Proprietary Trading
enforcement actions relating to side pockets, valuation,
Desks to Start-Up or Existing Hedge Fund Managers:
disclosure and other issues raised by illiquid assets in
The Talent Perspective (Part One of Three),” The Hedge
otherwise liquid hedge funds. Fund Law Report, Vol. 3, No. 49 (Dec. 17, 2010). Managers
with legacy side pockets and those launching new hedge
Structuring Recommendations funds with side pocket provisions are encouraged to disclose

Structuring decisions for a traditionally liquid manager clearly to investors the circumstances under which assets will
be put into and removed from side pockets; how assets in
contemplating investments in illiquid assets are invariably
side pockets will be valued; and the frequency with which
complex and highly fact-specific, but at least a few broad
valuations will be assessed, conducted and disclosed.
principles can be extracted from the foregoing discussion
and observation of current practice: hedge fund managers
would be well advised to hew close to their traditional skill
Philippe Simoens is a Senior Manager in Tax and Strategic Business
sets in investing, and to structure funds with terms that
Services for Weaver, an independent certified public accounting firm.
accommodate those traditional skills, especially in terms
Philippe’s practice emphasizes corporation and partnership tax planning
of liquidity. For example, if a fund manager has a skill in
and compliance, and he has experience in international, multistate
equity long/short investing, that manager may be able to
offer a hedge fund with reasonably frequent liquidity. See and local tax compliance matters. In terms of industries, Philippe

“Certain Hedge Funds are Using Enhanced Investor concentrates on the hedge fund and financial services industries, as well

Liquidity as a Marketing Tool,” The Hedge Fund Law as the manufacturing and distribution sectors. Within the hedge fund

Report, Vol. 2, No. 22 (Jun. 3, 2009). In those relatively and financial services industries, Philippe’s engagements have focused

rare circumstances where a manager has or acquires skill sets on taxation of financial products and trading strategies; reporting to
in both liquid and illiquid investing, that manager may be foreign, tax-exempt investors and ERISA plan investors; and federal
best served by pursuing those separate strategies in separate and multistate tax compliance for new and established alternative
vehicles, as opposed to pursuing the separate strategies in the investment entities, funds of funds, onshore and offshore master-feeder
same vehicle. On acquisitions by hedge fund managers and groups, investment advisory entities and financial institutions.


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