Unpacking hedge fund, co-investments and side pockets

How hedge fund, co-investments and side pockets can help investment portfolios

In recent years, hedge fund managers have been offering investors in their funds the opportunity to make individual investments, or co-investments, alongside the manager’s main fund.  The reason that hedge funds offer co-investments is that the investment opportunity may be too large for the hedge fund manager to undertake through their main fund, it may be less liquid than the rest of the investments in the main fund or it may not be consistent with the main fund’s investment strategy. Co-investment also allows the hedge fund manager to earn more money from their clients if their best ideas pan out as expected.

For investors, the attraction of co-investments is that the fees charged on them are significantly lower than those charged by hedge funds.  For example investing in a hedge fund typically costs 2% per annum in management fees and 20% of the annual investment gains, whereas managers may charge no management fees on co-investments and only charge an incentive fee of 10% of the investment gains, once they are crystallised.
Typically co-investment opportunities are offered by activist hedge funds that seek to buy minority stakes in underperforming companies and then attempt to create value by pressuring the board to change the management, divest parts of the business, return capital to shareholders or to leverage lazy balance sheets. The bigger the shareholding that the activist hedge fund manager can pull together through their main fund and with co-investors, the more leverage that they can exert on the target company’s board.  Similarly, distressed debt hedge funds may also seek co-investments to gain a stronger negotiating position in any restructuring of the company.

Side pocket investments are similar to co-investments as they represent a single, often illiquid, investment held by some investors in the main hedge fund but held in a separate fund referred to as a “side pocket” fund.  Side pockets are created when a large investment held by the hedge fund becomes illiquid, for example shares in a company are delisted, or the investment grows in value to become too large a part of the fund’s assets. Once the side pocket is created and the investment transferred into it, current investors get a pro-rata share of the proceeds of the side pocket fund once the investment is sold, whereas new investors coming into the hedge fund do not participate in the side pocket returns.

Whilst co-investment opportunities are potentially attractive to investors from a fee perspective and from the control that comes with selecting individual hedge fund investment ideas, they come with their own set of issues. Investors often need to sign confidentiality agreements before being shown details of the opportunity and then may only have a few days in which to decide whether to take up the co-investment. Many institutional investors may also not have the in-house investment team with capabilities to assess the merits and risks of the co-investment.  Another issue is that co-investments may increase the exposure to a particular investment which could turn out to be unsuccessful, for example US hedge fund Pershing Square offered investors in its main fund a co-investment in Target Corp which then lost 90% of its value in a year.  Also the co-investments are less liquid than investments in a pooled hedge fund often requiring investors to agree to lock up their capital for a year or longer.

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