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Side pocketing is very effective method used by fund houses to separate bad assets within a liquid fund.
The process of side pocketing was introduced by the Securities and Exchange Board of India. Over the years, SEBI realised that many asset management companies and mutual fund houses have massive exposure to risk which could drastically reduce their net asset value, thereby affecting investor returns. SEBI stated that a particular portfolio can only be constructed if there is a credit event at the issuer level in the form of downgrade of debt to below investment grade. Since the debt instrument is downgraded to default rating by credit bureaus, the mutual fund house has the option to facilitate side pocketing, so that the good assets can be preserved.
The process involves creating two schemes - one that contains illiquid paper and the other holds the healthy instruments. This type of fund segregation separates illiquid instruments from all other instruments in the portfolio that are liquid.
Let us illustrate an example to understand this process. Let’s assume that there is a fixed income mutual fund with a value of Rs. 1000 Cr., out of which 5% or Rs. 50 Cr. was owned by a company which defaulted. Since the company has defaulted, the new value of the fund stands at Rs. 950 Cr. In addition, key investors start redeeming their units from the mutual fund scheme in order to avoid any further loss.
In such a case, fund managers are forced to sell good paper, while the bad paper remains in the mutual fund scheme since it is illiquid and without any buyers. Due to this, the percentage holding of bad assets in the investment portfolio rises. This in return reduces the NAV, thereby hurting investor returns. To prevent this chain of events, the fund house segregates the debt papers of the affected company while the rest of the good paper remains invested in the original fund. Thus, the good paper is unaffected by the bad paper. In addition, all the investors will also get units of the side pocketed fund, but these would be allocated on a pro-rata basis. When the fund house receives money from the bad paper, the same is distributed among the investors.
Since side pocketing segregates the bad assets from the good assets, all existing investors in the mutual fund scheme are allotted equal number of units in the segregated portfolio as held in the main portfolio, but without any redemption or subscription options in the segregated portfolio. In order to facilitate exit of the unit holders, these units are listed on the stock market within 10 days. This makes the price discovery of the bad assets a transparent procedure. This gives an investor the freedom of either selling the units at a prevailing price or holding them if they expect the value to recover in future.
Since evaluations of bad paper/illiquid assets are contentious, the NAV will not be discoverable. This makes it difficult for investors to track two sets of NAVs.
Also, fund houses might misuse side pocketing to protect manager’s fees on the more liquid assets to hide poorly performing assets or poor liquidity management by its fund managers.
The Securities and Exchange Board of India (SEBI), has put in place checks and balances to minimise any such misuse of Side Pocketing. The regulator has asked trustees of all fund houses to put in place a framework that would negatively impact the performance incentives of fund managers, chief investment officers (CIOs), etc. involved in the investment process of securities under the segregated portfolio.
So, fund managers know that any creation of such side pocket in the future would also affect their own appraisals and incentives. In addition to this, SEBI has also said that side pocket should not be looked upon as a sign of encouraging undue credit risks as any misuse of the option would be considered serious and stringent action can be taken.
Side pocketing ensures that all the investors who are genuinely entitled to receive the benefits of the recovery in a fund will get it at a future date subject to realisation.
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