Data matters: Accounting and reporting

By Darren Berkowicz, SS&C Technologies

Published: 30 November 2021

Operational requirements for special situation opportunities

Hedge funds have experienced healthy growth throughout the pandemic, thanks to an abundance of opportunities to tap into a disrupted market. The diverse and alternative investment landscape has bolstered creativity in the hedge fund world, with managers using special situation accounts such as side pockets to tap into opportunities outside of their core strategy and mandate. Managers are using them in pursuit of asset classes with the potential for significant outperformance, including private equity and real estate investments, temporarily distressed, de-listed or thinly traded stocks, derivatives, and even cryptocurrencies. Such strategies require special care when dealing with data, especially in the context of accounting and reporting.

During the financial crisis of 2008-2009, regulators initially viewed these discretionary strategies with suspicion, concerned about the potential for abuse, opacity, over-valuation of assets leading to higher fees, and inadequate disclosures to investors. In the years since, however, side pockets have gained respect as a useful tool for investors. They protect funds from having to sell hard-to-value holdings to meet redemption demands while providing general and limited partners additional upside potential commensurate with the risks involved.

That said, side pockets pose complex operational, accounting and reporting challenges in order to deliver the accuracy and transparency that will satisfy both investors and regulators. Fund managers looking to take advantage of opportunities via side pockets should be aware of those challenges and the solutions needed to meet them.

Understanding side pockets

The intent of side pockets is to segregate illiquid and often higher-risk investments from the more liquid and traditional investments in a portfolio, but all within the context of a single legal entity. Side pocket investments may include new acquisitions or existing holdings that are reclassified as illiquid. Funds may have several side pockets at any given time.

At the time a side pocket is created, existing investors in the fund receive pro-rated shares in the side pocket through the conversion of a portion of their existing shares. The investors are then locked into their side pocket allocations until the underlying assets are liquidated or returned to the main portfolio, even if they redeem some or all of their shares in the general fund in the meantime. Investors thus retain a measure of liquidity with their general fund holdings while sharing in the potential upside (and risks) of the side pocket. Investors who come into the fund after the side pocket is created do not hold shares in the side pocket, nor do they participate in its profits or losses.

The operational impact

Understanding the inherent complexity of side pockets, some of the operational challenges become readily apparent:

Segregated and aggregated accounting: For accounting purposes, side pockets need to be tracked and values calculated on a stand-alone basis. However, accounting for the full fund entity must also include the side pocket. Since the true value of the side pocket asset is not realized until the liquidity event, managers must have and document a methodology for determining fair value during any accounting period. Fund firms need systems to perform both the segregated and aggregated accounting and deliver accurate and reliable net-asset -value calculations.

Investor accounting and reporting: With some fund investors participating in both the general portfolio and the side pocket, and others only invested in the general fund, managers need reporting capabilities to clearly show investors what they own and how their assets are performing.

Performance and management fee calculations: Fund managers must determine and disclose whether they are going to charge fees periodically throughout the side pocket duration or at the end when the actual return on the investment is realised. The former scenario applies primarily to management fees and involves a complex accrual and reconciliation process to ensure investors are charged fairly and accurately. Performance fees are usually not charged until the side pocket is liquidated and the true performance of the investment can be calculated. At a time when most investors are eschewing the traditional 2/20 fee model in favour of more customised arrangements, side pockets add another layer. 

It pays to outsource

While the intelligent use of side pockets presents enticing opportunities for potential gains, these vehicles can also impose enormous operational burdens. Many firms may be discouraged from side pocket ventures simply because they lack the operational infrastructure to support them. Others may discover too late their systems are not up to the task, raising a high risk of accounting errors, liquidity strains, regulatory scrutiny and investor dissatisfaction.

These issues can be mitigated by outsourcing to technology and operational service provider that has both a proven infrastructure and the specialised expertise to support side pocket investments. Those capabilities should encompass both portfolio and investor accounting and reporting for complex fund structures, as well as the ability to automate fee calculations and accommodate multiple bespoke fee schedules. Most importantly, the provider should have the capability to manage data complexity, ensuring a steady flow of clean, reconciled data throughout a hedge fund’s ecosystem. By assigning these responsibilities to an experienced provider, investment teams can take care of the operational complexities and focus on finding the right investment opportunities for their clients.