The concept of side-pocketing, in the context of mutual funds, has become relevant after the default by IL&FS and certain mutual funds giving negative returns. The negative returns have occurred because a few mutual funds have completely written off their exposure to IL&FS instruments, as a matter of prudent judgement, though Securities and Exchange Board of India (Sebi) rules allow them a much longer time frame.

As per Investopedia.com, “A side pocket is a type of account utilized in hedge funds to differentiate illiquid assets from more liquid investments. Once an investment enters a side pocket account, only the present participants in the hedge fund are entitled to a share of it. Future investors will not receive a share of the proceeds if the asset’s returns get realized.”

In our context, this term first came to light in 2015, when JP Morgan AMC was facing the issue of severe rating downgrade and potential default by one of the exposures in their portfolio, namely Amtek Auto. The broader issue in this kind of situation is that there is likely to be a rush of redemptions, leading to selling pressure on the fund, thus leading to sale of good assets in the portfolio. In the process, the extent of the bad asset, for example Amtek Auto, goes up automatically as the portfolio corpus size comes down to meet the redemptions and the bad asset has no takers. To face the situation, JP Morgan AMC stopped redemptions initially, as at that point of time there was no Sebi regulation specifically prohibiting AMCs from putting a stop to redemptions.

Now the big question: what will happen when redemptions are opened up? JP Morgan AMC side-pocketed the Amtek Auto exposures, which was there in two of their funds, and allotted units accordingly, of the “good fund” and the “bad fund” for the sake of simplicity.

The advantage of doing this was, there is no issue if investors want to redeem units of the “good fund” so to say, and the “bad fund”—i.e. the component with only Amtek Auto—is anyway not open to redemption. The management of JP Morgan Group was in touch with the issuer for realisation to the maximum extent possible.

Incidents similar to Amtek Auto have happened again and may recur in future as well. However, the process followed by JPM AMC has not been repeated. Why? In 2016, Sebi issued a regulation prohibiting stoppage of redemptions, except under certain extreme situations i.e. redemptions cannot be stopped in response to “Amtek Auto” kind of situations. On side-pocketing, though there is no official word yet from Sebi; it was requested informally on certain occasions post-JPM but rejected the requests. The context of today’s discussion is that Amfi (Association of Mutual Funds of India) has reportedly requested Sebi to allow side-pocketing for IL&FS, as the issue is wider now than on the earlier few occasions when it was not allowed by Sebi.

We will now discuss the pros and cons of side-pocketing. One reason to allow side-pocketing is, particularly when AMCs cannot stop redemptions, that it will benefit those who stay back. There would be retail investors who may not be aware of what is going on; for example, the IL&FS default in the current context. Otherwise, they will be left with poorer quality assets as the good assets in the portfolio would be sold off. It is interesting to see how AMCs have responded to this challenge. In a one-off case in 2017 and multiple AMCs in today’s context of IL&FS default have written off the exposure completely and stopped fresh purchases. This is a hard commercial decision for the management of any business, but they have taken the bold call. When the “bad asset” is written down to zero, it is a discount sale as the NAV (net asset value) comes down by as much, and anything that would be realised in future would be a bonus. When the AMC says they are not offering fresh units for purchase by investors in a particular fund, they are not allowing the unfair advantage of “discount sale”, but at the cost of their business development.

Another argument to allow side-pocketing is that redemption pressure itself will be low. If a bad asset like IL&FS is transferred into another side-scheme, for which the investor gets units allotted but is not open to redemption, business goes on as usual in the “good fund” as the problem exposure has been hived off.

Now let’s look at it from Sebi’s perspective as to why possibly they did not allow side-pocketing when requested earlier. It makes the fund manager complacent in managing credit-based/weak credit exposures as the unstated comfort is of hiving off the bad asset and doing business as usual. Moreover, as a rule, redemptions cannot be stopped by a mutual fund and if this is allowed, it will be a backdoor method as redemptions are not possible in the “bad” component of the fund. Maybe, as a one-off case in view of the wide ramifications of the IL&FS issue and debt mutual inflows being impacted adversely, it may be considered favourably.

Source: The concept of side-pocketing, how it matters | Mint (livemint.com)