Investment Funds and the Concept of “Side-Pocket”

[The following guest post is contributed by Pavit Singh Kochar, an advocate
practicing in New Delhi]
A popular
concept abroad that is yet to be practised extensively in India is a “Side-Pocket”,
which means
the segregation of the portfolio or funds to separate the illiquid investments
from the more liquid assets in the portfolio. This concept is used when a part
of the portfolio is not performing well and the entire portfolio should not
suffer because of it.
In a first in
the history of the Indian mutual fund industry, JP Morgan Asset Management
(India) Pvt. Ltd (“JPM”) has
proposed
to carve out affected portions of its portfolio by creating a
side-pocket for its two schemes: JP Morgan India Short Term Income Fund (“STIF”) and JP Morgan India Treasury
Fund (“TF”) into a separate units.
The process
followed for a side-pocket is that the scheme consists of number of units which
are held by the investors. These units in an existing scheme shall be split
into two different parts and different units will be allotted to the investors
in a pro-rata basis for representing the respective parts of the portfolio. The
main purpose for such segregation is to ensure that the overall portfolio
should not suffer due to small portion of illiquid investments in the
portfolio.
Impact
on the Investors by the Creation of a Side-Pocket
When a
side-pocket is created in the overall portfolio, existing investors who were
holding units in such overall portfolio will now be allotted units in two
holdings on a pro-rata basis. The profits and losses derived from such
side-pocket concept are allocated solely to the existing investors in fund
during the segregation. Since the assets in the portfolio are split between
various holdings, the Net Asset Value of the portfolio will be reduced and
transferred to the other units.
Investors tend
to resist the use of side-pocket schemes because the redemption of their
invested capital becomes more restricted. When a side-pocket is used, an
investor is compelled to retain that portion of its capital in the fund even if
the investor has otherwise decided to sell the units. This makes it difficult
for the investor to determine whether it will gain or suffer losses on its
overall invested capital.
Apart from the
above risk, the investor also gets the opportunity to earn regular liquidity
from the good investments even though a small portion of its invested capital is
affected. The units representing the illiquid investment may yield profits when
the investment is redeemed or sold.
In the JPM case,
the company has obtained the necessary majority approvals from the holders of
STIF and TF to segregate the assets of these two schemes. The segregation was
approved on account of the investment by STIF and TF in Amtek Auto Ltd turning
sour. Post segregation, one set of units will represent the investments in
Amtek Auto Ltd. and another set of units will represent all the other
investments and cash holdings.
Conclusion
The side pocket
should be exercised diligently and executed properly to help level the playing
field for investors in a fund which is experiencing liquidity issues. Creating
a side-pocket is not a simple solution for a difficult problem and various
operational and ethical issues must be considered before creating one.
– Pavit Singh
Kochar

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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