Side Pocket
A segregated sub-account isolating an illiquid or hard-to-value asset from a fund's main NAV, so redeeming investors aren't diluted by it.
Definition
A side pocket is a segregated sub-account within a fund used to isolate a specific illiquid, hard-to-value, or restricted asset from the fund's main, liquid NAV. Investors holding units at the time an asset is side-pocketed receive a pro-rata interest in that side pocket separate from their regular units; investors who redeem or subscribe afterward have no exposure to it either way.
Side pockets are typically used as an exception mechanism for a specific event — an asset that becomes illiquid, frozen, or impossible to fairly value with confidence — rather than an ongoing feature of a fund's structure. Common triggers in a crypto context include tokens locked under a vesting schedule, a pre-launch or otherwise illiquid allocation, or a position that becomes stranded when a venue halts withdrawals.
Because a side-pocketed asset is, by definition, hard to value reliably, performance fees on it are typically deferred until the asset is actually realized (sold or unlocked) rather than charged on an interim mark, so a manager can't collect a fee on an unrealized, potentially unreliable valuation.
Why it matters
Side pockets exist to protect the fairness of redemptions. Without one, a redeeming investor either gets diluted out of an illiquid asset they can't easily be paid for in cash (forcing the fund to sell it at a bad price to meet the redemption), or remaining investors bear an unfair share of an asset the redeeming investor should have kept some exposure to. Isolating the asset lets both the redeeming and remaining investors keep exactly the exposure they're entitled to.
For LPs, a side pocket also means part of their capital becomes illiquid indefinitely — often longer than the fund's normal lock-up period — since it can only be released when the underlying asset is actually realized, a real cost worth understanding even though the mechanism protects fairness overall.
How an asset gets side-pocketed
Designation into a side pocket typically requires the same trigger and process a fund pre-agreed in its offering documents — often manager discretion within defined criteria, sometimes with investor or board sign-off for larger funds. Once designated, the asset is carved out of the main NAV calculation entirely: investors' regular units are unaffected by its subsequent price moves, and a separate side-pocket interest, usually fixed as a percentage or dollar amount at the designation date, tracks the asset until it is realized.
Because the side-pocket interest doesn't participate in ordinary redemptions, investors who redeem their regular units while a side pocket is open typically still hold their side-pocket interest until that specific asset resolves — they don't get cashed out of it just because they exited the rest of the fund.
Common mistakes
Using side pockets routinely as a way to avoid marking a difficult asset honestly, rather than as a genuine exception for a specific illiquidity or valuation event.
Charging a performance fee on an unrealized side-pocket gain before the asset is actually sold or unlocked, which charges a fee on a valuation that hasn't been proven by an actual transaction.
Failing to pre-agree the criteria and process for using a side pocket in the fund's limited partnership agreement or private placement memorandum, leaving it as an ad-hoc manager decision investors never consented to in advance.
Assuming a side-pocketed asset's illiquidity is temporary and short — some crypto side pockets (a frozen exchange balance, a multi-year vesting schedule) can remain illiquid far longer than investors initially expect.
In practice
Crypto funds encounter side-pocket triggers traditional funds rarely face: a token allocation vesting over years, a position stranded when an exchange halts withdrawals, or a pre-launch allocation with no market price at all. Because these events can happen with little warning, funds that hold illiquid or vesting allocations commonly pre-agree side-pocket mechanics in their offering documents up front, rather than improvising terms after an event has already occurred.
A side-pocket decision interacts directly with a fund's valuation policy — the policy should specify in advance what triggers segregation into a side pocket, not leave that judgment call for the moment an asset actually becomes illiquid.
Questions, answered
What is a side pocket in a hedge fund?
A side pocket is a segregated sub-account that isolates a specific illiquid or hard-to-value asset from a fund's main NAV. Only investors holding units when the asset was designated get exposure to it, protecting both redeeming and remaining investors from unfair dilution.
Why would a fund use a side pocket?
Side pockets are typically used when an asset becomes illiquid, frozen, or too uncertain to value reliably — a locked or vesting token, a position stranded on a halted exchange, or a pre-launch allocation with no market price.
Can I redeem my side-pocket interest?
Generally not until the underlying asset is actually realized — sold, unlocked, or otherwise converted to cash — which can take considerably longer than the fund's normal redemption terms or lock-up period.
Do side-pocketed assets pay a performance fee before they are sold?
Typically no. Performance fees on side-pocketed assets are commonly deferred until the asset is actually realized, so a manager can't collect a fee against an unrealized valuation that hasn't been tested by an actual transaction.
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