One impaired loan, one redemption day, the fund run twice: with and without a side pocket, and what AIFMD II says about the tool.
A side pocket splits an open-ended fund in two: the hard-to-value asset moves into a separate class held by the investors on the day it is created, in proportion to their units, and dealing continues only in the rest. On an illustrative 500 million credit fund with a 60 million impaired loan, a 20 per cent redemption without a side pocket hands 7.2 million of loss from the leavers to the stayers; with one, both groups end at 9.28 per unit and the loss is shared exactly pro rata.
Worked in full in The AIFMD II Handbook by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
AIFMD II lists the liquidity management tools an open-ended AIF can use in Annex V. Side pockets are the last item on that list, alongside suspension, gates, notice periods, redemption fees, swing pricing, dual pricing, anti-dilution levies and redemptions in kind. The manager of an open-ended AIF has to select at least two tools from points 2 to 8 of the annex, which leaves out both suspension and side pockets: a side pocket can be in the documents, but it does not count towards the minimum of two. It is a tool for one asset that cannot be priced, not for a run on the fund.
| Item | Amount |
|---|---|
| Net asset value | 500 |
| Units in issue | 50 |
| Price per unit | 10.00 |
| Impaired loan, carrying value | 60 |
| Redemption requests at the next dealing day | 20% |
| Eventual recovery on the loan | 24 |
The borrower has missed a payment and is in restructuring. The loan, 12 per cent of NAV, is still carried at 60 because nobody can yet say what it is worth. It is eventually recovered at 24, 40 per cent of its carrying value, after the dealing day.
The fund pays the redeeming 10 million units at 10.00: 100 million in cash. The 40 million remaining units keep 400 million of assets, including the loan at 60. When the loan is realised at 24, the 36 million loss falls entirely on them: 364 million, or 9.10 per unit.
Fair price after the loss = (500 − 36) / 50 = 9.28
Redeemers received 10.00, stayers end at 9.10
Transfer to redeemers = 10 × (10.00 − 9.28) = 7.2 million
The stayers bear 36.0 million of loss against a fair share of 28.8. Nothing illegal happened; the fund simply paid out cash against a price that included an asset nobody could value. That is the dilution a side pocket exists to prevent.
Step 1, split the NAV. Before the dealing day the loan moves to a side pocket class. Main NAV is 500 − 60 = 440, or 8.80 per unit. The side pocket is 60, or 1.20 per unit.
Step 2, issue the side pocket units. Every holder on the record date receives one side pocket unit per main unit. The side pocket is closed: no subscriptions, no redemptions.
Step 3, deal in the main class only. Redeemers receive 10 × 8.80 = 88 million in cash and keep 10 million side pocket units.
Step 4, distribute the side pocket on realisation. The loan returns 24, or 0.48 per side pocket unit.
| Group | Main class | Side pocket | Total | Per unit |
|---|---|---|---|---|
| Redeemers, 10 million units | 88 | 4.8 | 92.8 | 9.28 |
| Stayers, 40 million units | 352 | 19.2 | 371.2 | 9.28 |
Both groups end at 9.28. The loss is 0.72 per unit for everybody, 7.2 per cent of the original NAV. The redeemers had their cash for the liquid part of their holding on time and wait only for the part that could not be priced.
New money is protected too. A 10 million subscription the day before the write-down, without a side pocket, buys 1 million units at 10.00 and absorbs 0.706 million of a loss it never had any exposure to when the loan was made. With a side pocket in place it buys main units at 8.80 and has no claim on the loan at all.
The transfer without a side pocket is the redeeming share times the gap between carrying value and recovery: 20% × (60 − recovery).
| Recovery | Of carrying value | Stayers' price, no side pocket | Fair price | Transfer to redeemers |
|---|---|---|---|---|
| 0 | 0% | 8.50 | 8.80 | 12.0 |
| 24 | 40% | 9.10 | 9.28 | 7.2 |
| 42 | 70% | 9.55 | 9.64 | 3.6 |
| 60 | 100% | 10.00 | 10.00 | 0.0 |
| 72 | 120% | 10.30 | 10.24 | -2.4 |
The side pocket is not a bet that the asset is worth less. If the loan recovers above its carrying value, the transfer runs the other way and the leavers would have given up 2.4 million to the stayers. The point is that nobody gets paid cash against a number that is a guess.
Whether the fund can meet the 20 per cent outflow at all, side pocket or not, is the subject of the redemption coverage ratio. The liquidity models for the book's credit fund are in the free workbooks for this case.
A side pocket replaces one price that includes a guess with two classes: a main class that can be dealt in and a closed class paid out when the guess becomes cash. On the worked fund it turns a 7.2 million transfer between investors into an identical 9.28 per unit for everyone. Under AIFMD II it is a permitted tool, but not one of the two the manager must select.
No. AIFMD II requires the manager of an open-ended AIF to select at least two tools from points 2 to 8 of Annex V. Suspension is point 1 and side pockets point 9, so neither counts towards the minimum. A side pocket can still be provided for in the fund documents and used for a single asset that cannot be valued, such as a 60 million impaired loan in a 500 million fund.
At creation the asset's carrying value is removed from the main NAV and each investor receives side pocket units in proportion to their holding. No dealing takes place in the side pocket; when the asset is sold or recovered, the proceeds are distributed. In the worked case a 60 million loan becomes 1.20 per unit and pays out 0.48 per unit on a 24 million recovery.
No. A gate limits how much is paid on a dealing day but not the price paid. Investors exiting behind a gate still receive a NAV that includes the unpriceable asset at its carrying value. On the worked fund, paying redemptions at 10.00 rather than the fair 9.28 transfers 7.2 million whether the payment is made at once or over several gated dealing days, as long as the loan is still carried at 60 when each payment is made.
This article is one calculation from The AIFMD II Handbook. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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