Side-Pocket Shenanigans

A recent SEC action against a San Francisco hedge fund is a reminder that ‘side pockets’ too often accompany style drift and account manipulation.

Years ago, when I was a reporter new to the private equity beat, a senior partner at a very established, brand-name buyout firm unexpectedly gave me a call, which turned into less of a conversation than a pedantic, one-minute lecture.

I had recently reported a comment made to me by an investor who had questioned whether or not a  deal done by this particular firm fell outside of its investment mandate. Apparently this partner read the anonymous quote and felt compelled to immediately pick up the phone.

That I would be contacted by anyone at this firm was surprising, because it had a reputation for being extremely press-shy. In fact, I’d never previously spoken to anyone at the firm, and I didn’t again speak to anyone at the firm until years later, when a new era of transparency forced it to be more publicly communicative.

The partner didn’t want to be quoted, and didn’t ask for a correction or retraction. Instead he said he called simply because I needed to understand something very important: his firm could do whatever it wanted with its investors’ money, go to any country, do any kind of deal in any industry, make any fiduciary decision. Got it?

And then the call was over. I was struck that this partner would be so chagrined that an investor had (apparently naively) expressed a hope that a fund manager stay within a pre-defined strategy. It seemed to me as if his first thought were not to reaffirm investor faith in his firm’s investment discipline, but to bludgeon those unaware of its omniscient divinity with a set of stone-hewn terms and conditions.

It seemed as if his intelligence had been insulted, along the lines of “investment mandates are for people who lack my genius.”

I was reminded of this conversation recently when I read the recent news that a San Francisco hedge fund manager, one Lawrence Goldfarb of BayStar Capital Management, had been made to pay a $14 million fine and was barred from the investment business for five years. His punishment was related to the misuse of a “side-pocket,” jargon for a set of illiquid assets segregated within a trading-focused hedge fund portfolio. Goldfarb’s use of his side pocket indicated the mindset of someone who felt entitled to take action on just about any investment opportunity deemed attractive, and then to reveal as little as possible about these deals to the peevish, vision-constrained investor base.

According to an SEC complaint, Goldfarb diverted some $6 million from his primarily PIPE-focused hedge fund into a series of investments that can most charitably be called “opportunistic:” a real estate fund, a “San Francisco record company” and a series of other private companies. He then shuffled proceeds from these investments into a series of accounts he controlled. Despite repeated investor inquiries about what was going on in BayStar’s side pocket, Goldfarb was less than forthcoming, or as the SEC puts it, he “directed his employees to send investors false written updates.”

Goldfarb probably imagined that he was doing exactly what his investors should have wanted him to do – leverage his amazing investment judgment, experience and connections to pursue attractive opportunities. However a detractor would say he drifted from his core competencies and vainly pursued deals that put his investors’ capital at undue risk, and then sought to avoid scrutiny by obscuring the mess inside his side pocket.

In too many cases, the existence of a significant side pocket within a hedge fund indicates that the manager has acquired a taste for private equity-style deals, a style of investing for which the firm may or may not be well equipped. But investors have usually allowed this to happen by agreeing to very broad or ill-defined investment mandates. This in turn can give the managers the idea that they can make just about any kind investment they want because, hey, their job is to be a genius.

Even in cases where managers create side pockets in the best possible faith, the cohabitation of liquid and illiquid assets can create all sorts of problems. Valuation issues can arise when investor redemptions come in – an investor who got cashed out when the side pocket was valued at $100 million will be incensed to learn that another investor who cashed out a month later got $200 million following an internal review. Illiquid side pockets are redemption-resistant, which can lead to unintended consequences. As was seen in the financial crisis, managers with sizeable side pockets were forced to oversell their liquid assets to meet redemptions, throwing their portfolio constructions out of whack. Many otherwise investor-friendly managers were forced to put up gates to protect the investors who were not bailing out.

It is now clear that side pockets were not always created in the best possible faith. Especially leading up to the heyday of hedge fund Babylon in 2007, the proliferation of side pockets accompanied a sense of lawlessness with regard to strategy and even a disdain for the notion that ambition should be guided by prior track record. It was the era of “I can make money from a stack of napkins.” It was the age of asset class “convergence,” which started with buyout guys feeling envy for their annual performance fee-taking cousins, but ended with hedge funds managers coming to enjoy the manly mano-a-mano negotiations and capital lock-up of private deals. Hedge funds increasingly bought into illiquid debt instruments and were showing up at private equity auctions and venture financings. All of these assets were stuck in side-pockets, and investors did not always enjoy clear terms on how the activities of these side pockets were to be reported and controlled. There is also evidence that managers manipulated their portfolios to stem the tide of redemptions, shifting assets to side pockets and claiming that liquidation was impossible.

Going forward, hedge fund investors should either require very specific parameters around side pocket usage, or ban them. If the manager of a trading-focused hedge fund wants to do one-off private deals, he should be required to try and raise a separate pool of capital around that strategy, just as is done in the private equity market (or at least, should be done). A stock picker should not do a private equity deal, and vice versa.

Setting better terms around side pockets is crucial because the pressure for hedge fund managers to stray may only grow over time. Some of them are running out of trading ideas. Inefficiencies that were once exploited have as a result become efficient. Many black boxes have been shown to contain only market beta. Inefficient private deals that place investor capital in long-term situations will be seen by hedge fund managers as increasingly desirable and prestigious. With regard to their beloved side pockets, managers would prefer to ask neither permission nor forgiveness. So be proactive and just say “no.”