nottheaverageactuary

Actuarial news and views from Cape Town and beyond

Side Pockets. A double edge sword?

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After the recent collapse of African Bank, 49 funds have segregated African Bank Investments Ltd (ABIL) shares from their investments by using a “side-pocketing” technique as of 20 August 2014. This is the first time the Financial Services Board (FSB) has allowed such a procedure in South Africa.

Side-pocketing is a process whereby illiquid assets (in this case ABIL shares) are separated from more liquid investments in a portfolio. After an investment enters a side-pocket account, only the present participants in the fund will be entitled to any increase in future value in ABIL shares. The capital related to such investment is not available for withdrawal until such investments are realized or otherwise become marketable securities. Future investors will not receive a share of these proceeds and will be protected from losses that may arise. This can be somewhat compared to a side pot in poker. It is seen as a method to carve out the bad assets and keep investor confidence in the funds.

Currently funds amounting to over R4.6 billion have been approved for these side-pocketing portfolios according to a FSB release. The creation of side-pocket funds doesn’t solve the problem but rather gives the issue a side-step. Some of the issue they create are:

  • Side pockets are sometimes seen as a way to protect fund manager’s fees by putting bad shares aside and they are usually never seen again. (Fund managers usually get paid a percentage of profits on funds and the fund would be inflated without the bad shares)
  • Complex issues may arise over the adjustment of High Water Marks. Investopedia explains High Water Marks as the highest value a fund manager has realised for that fund and thus may lead to conflict of interest in the future should the shares in the side pocket fund recover sufficiently.
  • Using side pockets has been viewed as adding a layer of secrecy and susceptible to abuse if the side pocket investments are not included in the fee calculations.

There are a number of issues that arise now that the FSB has allowed the side-pocketing process for ABIL shares. The FSB has somewhat opened a Pandora ’s Box.  When is it acceptable to use side-pockets? Does it become the natural go to answer for such problems in the future? Are we giving fund managers a license invest irresponsibly?

If implemented correctly, side pockets are a valuable mechanism to help deal with fund experiencing liquidity issues. Creating a side pocket is not a silver bullet for funds with liquidity issues and several key issues that must be considered before creating one. The main concern should be the fair treatment of all investors in the fund.

Here are a few articles that may be of interest :

CADIZ COLLECTIVE INVESTMENTS ABIL SIDE-POCKET CLIENT LETTER-http://www.cadiz.co.za/impact-of-exposure-to-african-bank-on-the-cadiz-unit-trust-funds/cadiz-collective-investments-abil-side-pocket-client-letter-august-2014/

http://www.businessweek.com/news/2014-08-18/south-african-money-managers-may-side-pocket-african-bank-debt

A list of approved side pocket portfolios-https://www.fsb.co.za/Departments/communications/Documents/Side%20Pocket%20Portfolios.pdf

http://www.iol.co.za/business/companies/investors-can-separate-african-bank-debt-1.1737491#.U_ZCqPmSy-Y

Definition of side pocket-http://www.investopedia.com/terms/s/sidepocket.asp

http://www.internationallawoffice.com/newsletters/detail.aspx?g=da6d290f-49de-49ca-9e7c-1db36641b7a6

What do you think about the use of side pockets?

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One thought on “Side Pockets. A double edge sword?

  1. This is similar to a bad bank. I think such approaches should only be used in real emergencies like the financial crisis, otherwise they can be abused.

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