Side Pocket Arrangements in Hong Kong Investment Funds: Governance and Investor Rights

Introduction to Side Pocket Arrangements

Side pocket arrangements are a mechanism used by investment fund managers to segregate illiquid, hard-to-value, or distressed assets from a fund's main portfolio. When a fund holds an asset that cannot be readily redeemed or accurately valued—such as a defaulted loan, an unlisted equity stake, or an asset subject to litigation—a side pocket allows the manager to separate that asset into a distinct sub-account. Investors in the fund at the time the side pocket is created retain a proportionate interest in the segregated asset, while new investors participate only in the main portfolio going forward.

In Hong Kong, side pocket arrangements are permissible for certain types of funds, particularly hedge funds and private credit vehicles. However, their use is subject to significant governance requirements, disclosure obligations, and investor consent considerations. This article explains the mechanics of side pockets, the regulatory framework that applies in Hong Kong, the key governance issues that fund managers must address, and the rights that investors can exercise when a side pocket is established.

What Are Side Pockets and Why Are They Used?

Side pockets serve several legitimate purposes in fund management. When a fund holds a liquid main portfolio alongside one or more illiquid or distressed positions, the presence of those illiquid assets can create inequities among investors. Without a side pocket mechanism, investors who redeem their interests may receive cash representing the full net asset value (NAV) of both liquid and illiquid assets. This can be unfair to remaining investors, who are left holding a proportionately larger share of the illiquid position. Conversely, if managers discount the illiquid asset's value heavily to facilitate redemptions, redeeming investors may receive less than their fair share.

Side pockets address this problem by segregating the illiquid asset so that it is no longer included in the NAV calculation for purposes of new subscriptions and redemptions. Investors present at the time of the side pocket creation retain their proportionate interest in the segregated asset and will receive their share of the proceeds when the asset is eventually realised—whether through a sale, repayment, or liquidation. New investors who subscribe after the side pocket is established do not participate in the side pocketed asset and are therefore not exposed to valuation uncertainty or liquidity risk associated with it.

Common scenarios that lead fund managers to establish side pockets include: a loan or bond in the portfolio going into default or restructuring; an unlisted equity investment becoming subject to a lock-up or transfer restriction; a counterparty becoming insolvent; or market conditions making it temporarily impossible to value or liquidate a position without significant market impact.

Types of Assets Typically Side Pocketed

While any illiquid or hard-to-value asset may be a candidate for a side pocket, the following categories are most commonly segregated:

Distressed debt and defaulted loans: Credit funds often hold loans or bonds that enter distress or default. When a borrower defaults, the fund manager may be unable to determine the recovery value of the instrument pending restructuring negotiations or insolvency proceedings. Side pocketing allows the manager to remove the uncertain asset from the main portfolio's NAV while preserving the economic interest of existing investors in any eventual recovery.

Unlisted equity stakes: Funds that invest in private companies may find that one or more of those companies has become subject to a lock-up, transfer restriction, or regulatory embargo that prevents an orderly sale. Side pocketing the stake prevents new investors from acquiring an indirect interest in the restricted asset and avoids unfair dilution of existing investors' economic rights.

Litigation assets: If a fund holds an asset subject to litigation—such as a loan in dispute or a claim under an insurance policy—the outcome and timing of the litigation may be highly uncertain. Side pocketing allows the manager to segregate the litigation asset and distribute proceeds to eligible investors once the matter is resolved.

Regulatory or sanctions-restricted assets: In some cases, regulatory action or the imposition of international sanctions may make it impossible to sell or value a particular holding. Side pocketing the affected asset while the fund continues to operate normally with its remaining portfolio can be a pragmatic solution, provided it is properly disclosed to investors.

The Regulatory Framework in Hong Kong

In Hong Kong, the regulation of investment funds depends on the type of fund structure and whether it is offered to retail or professional investors. The Securities and Futures Commission (SFC) regulates collective investment schemes authorised for sale to retail investors under the Securities and Futures Ordinance (SFO) and the Code on Unit Trusts and Mutual Funds. For hedge funds and other funds offered only to professional investors, the regulatory framework is less prescriptive but still imposes requirements on fund managers who hold a Type 9 (Asset Management) licence.

SFC-authorised funds: For retail funds authorised by the SFC, the use of side pockets is generally not permitted without SFC approval. The Code on Unit Trusts and Mutual Funds does not contain explicit provisions permitting side pocket arrangements, and retail fund managers who wish to establish a side pocket would need to seek SFC guidance or approval. Given the SFC's focus on investor protection, approval is unlikely to be granted except in extraordinary circumstances.

Professional investor funds: Hedge funds and other funds limited to professional investors have more flexibility. The SFC's licensing conditions for Type 9 licence holders require compliance with applicable fund documents, but do not impose a blanket prohibition on side pockets. Fund managers may establish side pockets if the fund's constitutional documents (typically the offering memorandum and limited partnership agreement or trust deed) expressly permit them.

Open-Ended Fund Companies (OFCs): The OFC regime, introduced in Hong Kong in 2018, allows for the establishment of umbrella structures with multiple sub-funds. While the OFC Code and accompanying guidelines do not specifically address side pockets, OFCs managed as hedge funds for professional investors may incorporate side pocket provisions in their offering documents. Managers should confirm the position with the SFC if considering side pockets within an OFC structure.

Limited Partnership Funds (LPFs): The LPF regime, introduced in 2020, is commonly used for private equity and private credit funds. LPFs are private contractual arrangements governed by limited partnership agreements. Side pocket provisions can be incorporated into the LPA, subject to investor consent and appropriate disclosure in the offering documents.

Constitutional Document Requirements

The starting point for any side pocket arrangement is the fund's constitutional documents. Fund managers cannot unilaterally establish a side pocket unless the offering memorandum, prospectus, limited partnership agreement, or trust deed expressly permits them to do so. Where the constitutional documents are silent, the manager would typically need to seek investor consent before segregating any asset.

Well-drafted side pocket provisions should address: the definition of eligible assets that may be side pocketed; the trigger conditions or events that may lead to side pocketing; the valuation methodology to be applied to the side pocketed asset; the allocation of management fees and performance fees in respect of side pocketed assets; the treatment of expenses, including legal costs, attributable to the side pocketed asset; the mechanism for distributing proceeds from the side pocketed asset to eligible investors; and the process for terminating the side pocket once the asset has been realised.

Managers reviewing existing fund documents should assess whether their side pocket provisions are clear and comprehensive. Ambiguous or incomplete provisions can give rise to investor disputes and regulatory scrutiny.

Investor Consent and Notification

The requirement for investor consent varies depending on the fund's constitutional documents and the applicable regulatory framework. In some fund structures, the manager has unilateral authority to establish a side pocket for defined categories of assets, without any requirement to seek investor approval. In others, the establishment of a side pocket requires a simple majority or supermajority approval from investors.

Even where unilateral authority exists, best practice requires the manager to notify investors promptly when a side pocket is established. The notification should include: a description of the asset being side pocketed; the reason for the segregation; the estimated value of the side pocketed asset, if determinable; the impact on the fund's NAV and redemption terms; the management fee and performance fee arrangements that will apply; and the expected process and timeline for realising the asset.

Investors who receive inadequate or delayed notification may have grounds for complaint to the SFC or for civil action against the manager. In Hong Kong, the SFC has the power to investigate and take disciplinary action against licensed fund managers who fail to deal fairly with investors or who fail to make timely and adequate disclosure.

Valuation of Side Pocketed Assets

Valuation is one of the most challenging aspects of side pocket administration. By definition, side pocketed assets are difficult to value—otherwise they would remain in the main portfolio and be marked to market in the usual way. Fund managers must establish a fair and consistent valuation policy for side pocketed assets, which typically involves one or more of the following approaches:

Independent valuation: The manager engages an independent third-party valuator—such as an accounting firm, investment bank, or specialist asset valuer—to provide a fair value estimate. This is the most robust approach and is generally required for larger or more complex side pocketed assets.

Cost basis or last known value: Where independent valuation is impractical or disproportionately expensive, the manager may initially carry the side pocketed asset at its last known fair value or cost basis. This approach should be clearly disclosed to investors and reviewed regularly.

Nil or nominal value: In cases where recovery is highly uncertain—such as a defaulted loan in complex restructuring negotiations—the manager may write down the side pocketed asset to nil or a nominal value pending resolution. This approach, while conservative, can give rise to performance fee crystallisation issues if the eventual recovery exceeds the written-down value.

Hong Kong-licensed fund managers have a general obligation under the SFC's Fund Manager Code of Conduct to ensure that assets are valued fairly and consistently. Managers should document their valuation methodology and rationale, and review the carrying value of side pocketed assets at least annually or whenever a material development occurs.

Management Fees and Performance Fees

The treatment of management fees and performance fees in relation to side pocketed assets is a significant governance issue. Investors generally expect that: management fees should not be charged on the full value of the side pocketed asset if it is written down to a low or nil value; performance fees should not be charged on unrealised gains attributable to the side pocketed asset until proceeds are actually received; and performance fees, if charged on recovery proceeds, should be calculated in a way that is consistent with the fund's high-water mark provisions.

Fund managers should review their fee provisions carefully when establishing a side pocket. Charging full management fees on a side pocketed asset that has been written down to a minimal value could be seen as taking advantage of investors. Conversely, managers who continue to incur significant costs in managing and recovering a side pocketed asset—such as legal fees or restructuring advisor costs—may legitimately argue that some fee income is appropriate to cover those costs.

Where performance fees are charged on the realisation of a side pocketed asset, fund managers should consider whether the relevant high-water mark provisions apply. In some fund structures, the side pocket is treated as a separate account with its own performance fee calculation, while in others the recovery proceeds are included in the main portfolio's performance calculations.

Redemptions and New Subscriptions During Side Pocket Period

One of the key features of a side pocket is that it prevents new investors from participating in the segregated asset. After the side pocket is established, new subscriptions are allocated only to the main portfolio. This ensures that new investors are not exposed to the illiquid or distressed asset and that existing investors are not diluted by new entrants.

For existing investors who wish to redeem their interests in the main portfolio, the redemption process generally continues as normal—they receive the NAV of their interests in the main portfolio and are issued a side pocket interest certificate or similar instrument representing their economic interest in the segregated asset. The side pocket interest typically cannot be redeemed until the asset is realised; it can, in some cases, be transferred to a third party, subject to the fund's constitutional documents and applicable law.

Managers should ensure that their subscription and redemption documentation clearly explains the existence and terms of any side pocket to prospective investors. Failing to disclose an existing side pocket at the time of a new subscription could expose the manager to claims of misrepresentation or breach of fiduciary duty.

Realisation and Winding Up of Side Pockets

Once a side pocketed asset is realised—through sale, recovery, settlement, or liquidation—the proceeds are distributed to eligible investors on a pro-rata basis. The manager should notify investors promptly of the realisation and provide a statement of the gross proceeds, applicable fees and expenses, and the net amount distributable to each eligible investor.

If the side pocket cannot be realised within a reasonable period—for example, because the underlying asset is subject to ongoing litigation or insolvency proceedings—the manager should consider whether it is appropriate to transfer the side pocket interest to a liquidating vehicle or to seek investors' instructions on next steps. In some cases, a prolonged side pocket arrangement may effectively result in the fund operating two separate pools of assets indefinitely, which can be operationally and administratively burdensome.

Fund managers should build clear sunset provisions into their side pocket arrangements from the outset, specifying the maximum duration for which a side pocket may remain in place before investors must be consulted on the appropriate course of action.

Investor Rights and Remedies

Investors in Hong Kong funds who are concerned about the use of side pockets have several avenues for recourse. First, investors should review the fund's constitutional documents to assess whether the side pocket was established in accordance with the fund's stated terms. If the manager has acted outside its authority, investors may have a contractual claim for breach of the fund agreement.

Second, investors may complain to the SFC if they believe a licensed fund manager has acted unfairly, failed to make adequate disclosure, or otherwise breached its regulatory obligations. The SFC has the power to investigate, impose conditions on a licence, suspend or revoke a licence, and take civil or criminal proceedings in serious cases.

Third, investors may consider civil litigation against the fund manager for breach of fiduciary duty, breach of contract, or misrepresentation. Hong Kong's courts have jurisdiction over disputes involving Hong Kong-domiciled funds and Hong Kong-licensed managers, and investors can seek damages, injunctions, or other relief.

Fourth, in funds that have a supervisory board, investment committee, or advisory committee, investors may seek to use those governance structures to scrutinise and challenge a side pocket arrangement.

Best Practices for Fund Managers

Fund managers operating in Hong Kong should adopt the following best practices when dealing with side pocket arrangements: ensure that constitutional documents clearly and comprehensively address the circumstances in which side pockets may be used and the governance process that applies; establish a clear written policy for valuing side pocketed assets and review that valuation regularly; notify investors promptly and fully whenever a side pocket is established, modified, or wound up; consider establishing an independent valuation committee or engaging an independent valuator to provide credibility and protect the manager from conflicts of interest; document all decisions relating to side pockets, including the rationale for establishing the side pocket, the valuation methodology, the fee arrangements, and the expected realisation timeline; and review side pocket provisions as part of any periodic review of the fund's offering documents to ensure they remain current and reflect best market practice.

Conclusion

Side pocket arrangements are a practical tool for managing illiquid or distressed assets in investment funds, but their use raises significant governance, regulatory, and investor relations considerations. In Hong Kong, fund managers must ensure that side pockets are authorised by the fund's constitutional documents, that investors receive timely and complete disclosure, and that the valuation, fee, and realisation processes are conducted fairly and consistently.

Investors, in turn, should familiarise themselves with the side pocket provisions in any fund they invest in and understand the circumstances in which their interests may be partially locked up. Alan Wong LLP's Investment Funds practice advises fund managers and investors on all aspects of side pocket arrangements, from reviewing constitutional documents to advising on investor rights and regulatory compliance. Contact us to discuss your fund governance or investment dispute requirements.