Side Pocket Provisions in Hong Kong Fund Documents: A Practical Guide

Side Pocket Provisions in Hong Kong Fund Documents: A Practical Guide

Side pocket provisions allow fund managers to segregate illiquid, hard-to-value, or restricted investments into a separate account or class of interests, protecting liquid investors from illiquidity while preserving the fund's ability to continue managing its portfolio through periods of market dislocation. The mechanics are straightforward in theory but require careful legal drafting and disciplined governance to function properly. This article examines how side pockets operate under Hong Kong law, when they are triggered, how they should be documented in limited partnership agreements and fund constitutional documents, and what protections should be negotiated by sophisticated investors.

The Origin and Purpose of Side Pockets

Side pockets became commonplace after the 2008 global financial crisis, when hedge fund managers faced a acute dilemma: large portions of their portfolios consisted of illiquid investments (distressed debt securities, restricted equity stakes, private equity co-investments, or over-the-counter derivatives) that could not be sold at or near fair value on a liquid market without materially moving prices or triggering fire-sale losses. Simultaneously, many hedge funds faced waves of redemption requests from investors seeking to withdraw capital. The managers needed a mechanism to permit liquid investors to redeem while segregating the illiquid assets, preventing the redemption pool from being depleted by forced sales of illiquid positions at depressed prices.

The side pocket mechanism solved this problem elegantly: illiquid investments were transferred into a separate account, and investors who held fund interests at the time of the transfer received a pro-rata interest in the side pocket; new subscribers after the transfer received no interest in those illiquid assets. The side pocket operated independently from the main portfolio—redemptions from the main fund proceeded normally, but redemptions from the side pocket were deferred until the illiquid investments could be realised.

While the device originated in the hedge fund industry, side pockets have become increasingly relevant for other investment vehicles: multi-strategy funds, credit funds (which may hold positions that become illiquid during credit dislocations), real asset funds, and even some equity long-only vehicles facing tail-risk scenarios. Understanding side pocket mechanics is therefore essential for any investor in non-liquid investment vehicles.

Legal Nature and Statutory Foundation

A side pocket is not a separate legal entity; rather, it is a segregated account or class of interests within the existing fund structure. For a limited partnership fund (LPF), the side pocket is created by designating certain securities as "Designated Investments," transferring those securities into a segregated account, and issuing side pocket partnership interests (representing a share of that segregated account) to existing limited partners on a pro-rata basis. For a trust-based fund, the mechanism may involve creating a new class of units representing side pocket assets, or transferring side pocket assets into a separate trust. For a company-based open-ended fund company (OFC) structure, the mechanism typically involves creating a new share class representing side pocket interests.

The legal foundation for a side pocket is the fund's constitutional documents. A side pocket cannot be created unless the Limited Partnership Agreement (for an LPF) or the trust deed or instrument of incorporation (for other structures) expressly permits the general partner or manager to establish a side pocket and specifies the conditions under which designation occurs. In the absence of express documentary authority, the general partner has no right to unilaterally segregate assets, as doing so would alter the nature of the partnership interest without the limited partners' consent and would potentially breach the general partner's fiduciary duty of loyalty.

Conditions for Side Pocket Designation

The LPA or constitutional document must specify the conditions under which a side pocket may be established. Typical conditions include the following:

Illiquid Designation. An investment is designated as illiquid if it cannot be readily sold at or near its fair market value within a reasonable period (typically defined as "within 30 days") without materially adversely affecting the price. This condition captures investments for which no liquid secondary market exists or for which the fund's holding is too large to be sold without moving the market. Examples include restricted securities, over-the-counter derivatives, and illiquid credit instruments.

Hard-to-Value Designation. An investment may be designated if there is no reliable market price available and the fair value must be determined through estimation or valuation modeling. This condition applies to investments for which pricing data is sparse or volatile, such as distressed securities, private equity stakes, or bespoke derivatives. Hard-to-value investments are particularly important for side pocket mechanics because the absence of reliable pricing makes it impossible for the fund to calculate a fair daily or monthly net asset value (NAV) that accurately reflects the investment's true value. Placing the investment in a side pocket allows the main portfolio NAV to be calculated without the uncertainty introduced by the valuation estimate.

Regulatory or Contractual Restrictions. An investment may be designated if its transfer is restricted by regulatory requirement or by contract. Examples include securities subject to transfer restrictions under securities law (Rule 144 restricted securities in the United States), equity stakes subject to lock-up agreements in private equity co-investments, or investments held by a manager where the investment agreement prohibits transfer without consent of the co-investors. These restrictions may be temporary (lock-up expires after a specified period) or permanent (certain controlled securities cannot be transferred without SEC registration).

General Illiquidity or Fund Stress. Some LPAs permit the general partner to designate investments as illiquid in circumstances of "general market disruption" or where the fund faces collective redemption pressure such that forced liquidation of illiquid positions would be detrimental to remaining investors. This is a broader trigger that gives the manager discretion to invoke the side pocket mechanism to protect the fund during periods of acute market stress. This discretionary trigger should be subject to reasonably strict conditions and notification requirements to prevent abuse.

Documentation Requirements: Limited Partnership Agreements

A well-drafted side pocket provision in an LPA should address the following elements:

Definition of Designated Investment. The LPA should define precisely what constitutes an investment eligible for side pocket designation. This definition should be cross-referenced with the illiquidity and hard-to-value conditions. The definition should also specify any investments that are not eligible—for instance, investments that have fallen in value may be illiquid, but the manager should not have the right to side-pocket them merely to segregate the loss from the main fund's NAV.

Designation Procedure. The LPA should specify who has the right to designate an investment (typically the General Partner or an Investment Committee), what process must be followed, and what notice must be given. A common provision requires the General Partner to provide written notice to Limited Partners and to the Limited Partnership Advisory Committee (if one exists) within a specified period (e.g., 5 business days) of the designation, including the rationale. Some LPAs require a majority of Limited Partners (or a supermajority) to consent to the designation, which provides investor protection but may be impractical if the fund has a large number of limited partners.

Mechanics of Allocation. The LPA should specify how side pocket interests are allocated to existing limited partners. The standard mechanism is pro-rata allocation based on each limited partner's ownership percentage in the main fund at the time of designation. However, the LPA might specify alternative mechanisms: allocation only to limited partners who were invested on a specified "as-of" date prior to designation, or allocation only to limited partners who do not have pending redemption requests.

Fee Treatment. The LPA should clearly specify whether management fees and performance fees apply to the side pocket. There are several possible approaches: (a) no fees on the side pocket until the investment is realised (common approach, as the side pocket investment is not actively managed); (b) reduced management fee (e.g., 0.5% on side pocket assets, compared to 1.5% on main fund assets); (c) management fee suspended until realisation, but performance fee applies to gains when realised. The choice depends on the fund's fee structure and fairness considerations for investors. Allocating full fees to illiquid assets that may not be realised for years is generally considered unfair and should be avoided.

Valuation and Reporting. The LPA should address how side pocket investments are valued for reporting purposes. Common approaches include: (a) valued at cost until realised; (b) valued at the most recent reliable market price or HKMA valuation (if one exists); or (c) valued at fair value estimated by the General Partner, with periodic revaluation. The main fund's NAV should exclude the side pocket from the calculation, so the side pocket does not affect daily or monthly NAV calculations of liquid fund shares. Separate reporting should be provided to side pocket interest holders showing the valuation of each side pocket investment.

Redemption Suspension. The LPA should specify that redemptions of side pocket interests are suspended until the underlying investment is realised or can be distributed in kind. The provision should address what happens to side pocket interest holders who wish to exit the fund: they may receive the side pocket interests in-kind upon fund exit (retaining their interest in the side pocket until realisation), or they may be required to retain their side pocket interests indefinitely until realisation.

Dissolution and Wind-Down. The LPA should specify what happens if the fund dissolves before side pocket investments are realised. Typically, side pocket investments are distributed in kind to side pocket interest holders as the fund is wound down, or are held in a residual entity or trust until realisation occurs. The LPA should contemplate arrangements for managing the side pocket investments after the main fund has been closed and dissolved.

Documentation for Trust-Based and Company-Based Funds

For trust-based funds (trusts issued as units) or company-based funds (OFC structures), side pockets are implemented through creation of separate classes or series of units or shares. The trust deed or instrument of incorporation should specify: (a) the mechanism for creating a side pocket class (which may involve the trustee or manager creating the class unilaterally or with consent); (b) the conditions for transferring investments to the side pocket class; (c) the allocation of side pocket interests to existing unitholders or shareholders; and (d) the fee and redemption mechanics applicable to the side pocket class.

For OFCs, which are increasingly used as vehicles for Hong Kong funds, the constitutional document should be very specific about the side pocket mechanics because the OFC structure does not involve a partnership agreement and relies entirely on the instrument of incorporation and board resolutions to establish the terms. The SFC's authorisation of the fund should contemplate side pocket mechanics in the offering document, and the SFC should approve any amendments that introduce or modify side pocket provisions.

Investor Protections: Negotiating Side Pocket Terms

Sophisticated institutional investors will typically negotiate side letter or side agreement provisions addressing side pockets. Key investor protections include the following:

Cap on Designated Assets. Investors should negotiate a provision that limits the percentage of the main fund's NAV that can be designated as illiquid at any point in time. Common caps range from 15% to 25% of NAV. This provision prevents the General Partner from siphoning off substantially all assets into side pockets and leaving the main fund with only highly liquid core holdings. A lower cap (e.g., 10%) may be negotiated by investors with significant leverage or by investors concerned about the manager's historical use of side pockets.

Notification and Cure Period. Investors should require that they be notified promptly—within 2–5 business days—of any side pocket designation. Some side letters provide a "cure period" allowing the General Partner to cure the illiquidity before a formal designation takes effect (e.g., by finding a buyer for the position or refinancing it). This gives the manager an incentive to explore alternatives to side-pocketing.

Information Rights. Investors should negotiate detailed information rights pertaining to side pocket investments: quarterly or monthly valuation of side pocket assets, detailed descriptions of each side pocket investment including the reason for designation, expected timeline for realisation, and valuation methodology. The investor should also have the right to request that management engage an independent valuator to assess hard-to-value side pocket investments, particularly if the side pocket remains in existence for extended periods.

In-Kind Distribution Right. Investors should negotiate a right to receive side pocket interests in-kind upon redemption from the main fund, rather than being forced to hold side pocket interests indefinitely pending realisation. This gives the investor optionality: the investor can redeem the main fund and decide separately whether to hold or attempt to disposition the side pocket interests.

Most Favoured Nation Provision. If an anchor investor or co-investor receives more favourable side pocket terms than other investors, other sophisticated investors should negotiate an MFN provision requiring the General Partner to extend the same terms to all investors. This prevents the manager from providing preferential treatment to certain investors regarding side pocket mechanics.

Removal of General Partner for Abuse. Investors should ensure that the LPA or side letter contains a provision allowing Limited Partners (by a specified majority vote) to remove the General Partner for serious breaches, including misuse of the side pocket mechanism to segregate assets for improper reasons (e.g., to inflate management fees or hide underperformance from the main fund).

General Partner Fiduciary Duties and Side Pocket Governance

The General Partner's fiduciary duty to act in the best interests of all Limited Partners is paramount and applies directly to the side pocket designation decision. A side pocket can be established only if the designation is reasonably justified by the conditions specified in the LPA and is made in good faith for the stated purpose (segregating illiquid assets to protect the main fund). If a General Partner designates an asset as illiquid when the asset is in fact readily saleable, or designates an asset primarily to avoid mark-to-market loss on the main fund's NAV, the General Partner is in breach of fiduciary duty and may be liable to Limited Partners for damages.

Case law addressing fiduciary duty in side pocket contexts is limited in Hong Kong, but principles of trust law and partnership law clearly establish that the General Partner must act in good faith and in the best interests of the partnership. Accordingly, the General Partner should document the designation decision carefully, including contemporaneous memoranda explaining the reason for designation and supporting the characterization of the investment as illiquid or hard-to-value. This documentation serves both as a governance record and as evidence that the decision was made in good faith.

If the fund has a Limited Partnership Advisory Committee (LPAC), some LPAs require the LPAC to review and consent to side pocket designations above a certain threshold (e.g., any single designation above 5% of NAV, or cumulative designations exceeding 15% of NAV). This provides an additional governance layer and may reduce the risk of abuse, though it does not eliminate the General Partner's fiduciary duty.

SFC Considerations for Authorised Funds

For funds authorised by the SFC under the Securities and Futures Ordinance (Cap. 571), side pocket provisions must be disclosed in the fund's offering document and must be approved by the SFC. The SFC's approach has evolved over time, but the Authority generally permits side pocket mechanisms provided they are: (a) clearly disclosed to investors; (b) limited to investments that genuinely meet the specified conditions; and (c) subject to clear governance and information rights.

If a fund intends to introduce side pocket provisions after initial authorisation, an amendment to the offering document and SFC approval will be required. Managers should not unilaterally introduce side pockets without updating the offering document and obtaining SFC approval, as doing so would be a material change to the fund's prospectus and would potentially violate the SFO.

For private funds distributed to professional investors under an exemption from authorisation, side pocket mechanics are principally governed by the LPA and investor side letters, though the manager's other SFC-licensed activities (if any) must be consistent with the side pocket arrangements.

Common Mistakes and Pitfalls

Over-Use of Side Pockets to Avoid Redemptions. Some managers have been observed using the side pocket mechanism to avoid granting redemptions to investors who have requested exit. For instance, a manager facing significant redemption requests might designate a large portion of the fund as illiquid and place it in a side pocket, reducing the liquid NAV available for redemption and forcing the requesting investor to retain a side pocket interest indefinitely. This misuse constitutes a breach of fiduciary duty and contractual violation, and may expose the manager to investor litigation. Side pockets should never be used as a mechanism to prevent redemptions; they exist only to segregate legitimately illiquid assets.

Inadequate Documentation of Designation. Some General Partners have failed to maintain adequate contemporaneous documentation supporting the reason for side pocket designation. Later, when investors challenged the designation, the General Partner could not produce credible evidence supporting the illiquidity determination. Proper governance requires that each designation decision be documented in a memorandum explaining the factual circumstances supporting the illiquidity or hard-to-value determination. This documentation should be maintained in the fund's records and made available to investors upon request.

Fee Charging on Illiquid Investments. Some fund documents specify that full management fees and performance fees are charged on side pocket assets. This is often unfair: if a side pocket investment is not realised for 5–10 years, charging annual management fees on the investment throughout that period extracts fees from the Limited Partners without any active management occurring. Best practice is to suspend management fees on side pocket assets and only charge performance fees on realisation of gains. The LPA should be explicit on this point.

Inadequate Valuation Procedures. Side pocket valuations can be subject to significant estimation and judgment, particularly for hard-to-value investments. Inadequate or opaque valuation procedures can give rise to investor disputes and potential claims of breach of fiduciary duty. The LPA should specify a clear valuation methodology and should provide for periodic independent valuation (by an independent auditor or valuation specialist) of side pocket investments, particularly if the side pocket has not been realised within a reasonable period (e.g., two years).

Failure to Timely Close Out Realised Side Pocket Investments. Once a side pocket investment is realised, the proceeds should be distributed to side pocket interest holders promptly. Failure to close out a side pocket investment after realisation (e.g., holding the proceeds in cash awaiting some triggering event) creates investor dissatisfaction and potential fiduciary duty questions. The LPA should specify the timeline for distribution of proceeds after realisation (typically within 30–60 days).

Current Market Practices and Trends

Side pocket provisions have become nearly universal in hedge fund and multi-strategy fund documents in Hong Kong and globally. However, the increased use of side pockets during periods of market stress (notably, the 2022 credit dislocations following the collapse of certain cryptocurrency lending platforms) has prompted investor scrutiny. Institutional investors are now negotiating significantly tighter side pocket terms, with lower caps on designated assets, shorter expected realisation timelines, and more detailed information rights. Managers establishing new funds should anticipate these investor demands and should draft side pocket provisions that are appropriately balanced between manager operational flexibility and investor protection.

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This article is for general information and educational purposes only. It does not constitute legal advice and should not be relied upon as such. Laws and regulatory requirements are subject to change. You should seek independent legal advice in relation to your specific circumstances before taking any action or relying on any information in this article.