Tokenized Side Pockets and Illiquid Assets: How Institutional Funds Ring-Fence Illiquidity

Side pocketing is the established mechanism through which open-ended funds ring-fence illiquid or hard-to-value positions, ensuring that investors who hold those positions when they become illiquid retain the economic exposure and that subsequent investors are not exposed to assets they did not subscribe for. The mechanism is well understood in non-tokenized hedge funds. In a tokenized fund, the same economic principle applies, but the implementation must accommodate two records of ownership and a transfer restriction layer that operates at the smart contract level. This article sets out how side pockets and illiquid assets are handled in a tokenized Cayman fund structure that allocators can underwrite.

"The tokenized representation does not change the institutional logic of side pocketing. It changes the operational architecture through which the side pocket is administered. The principal design decision is whether to express the side pocket as a separate class of fund interest, represented by a separate class of token, or as a separate segregated portfolio within an SPC. Both approaches are coherent. The choice is governed by the strategy, the investor base, and the operational complexity the manager is prepared to support." David Lloyd, Chief Executive Officer of CV5 Capital

What Side Pocketing Is and Why It Exists

A side pocket is a designated portion of a fund's portfolio, segregated from the main portfolio for valuation and redemption purposes, in which positions that have become illiquid, hard to value, or otherwise inappropriate for inclusion in the daily NAV are held. Investors who hold interests in the fund at the time the side pocket is established receive a corresponding interest in the side pocket. Subsequent subscribers receive interests only in the main portfolio. Investors who redeem before the side pocket positions are realised retain their exposure to the side pocket until those positions are liquidated, at which point the side pocket distributes proceeds to the relevant investors and is closed.

The mechanism solves an equity problem. If illiquid positions remain in the main portfolio at uncertain valuations, subsequent subscribers acquire exposure to assets the manager cannot reliably value, redeeming investors take pro-rata distributions of value that may not be realisable, and the integrity of the daily NAV calculation is compromised. Side pocketing isolates the affected positions, preserves the economic interest of the investors who originally subscribed for them, and protects the integrity of the main NAV.

For digital asset funds, the circumstances that trigger side pocketing are familiar. A position in a token whose primary venue has suspended trading. A protocol exposure where a withdrawal mechanism has been gated by governance action. A staked or locked position whose unbonding period extends beyond the fund's normal valuation cycle. A position in a token subject to litigation or regulatory action that materially affects its tradeability. Each of these scenarios calls for the same institutional response: ring-fence the affected position, communicate the action to investors, value the side pocket on a basis appropriate to its illiquid character, and progress the realisation of the position through the documented procedure.

The Two Principal Implementation Models in a Tokenized Fund

Model One: Class-Specific Side Pocket Tokens

The first implementation model uses share or partnership interest classes within a single fund vehicle to express the side pocket. The fund's constitutional documents authorise the creation of a side pocket class on terms set out in the offering memorandum, and the board, on the recommendation of the manager and with any required approvals, designates the side pocket class when the conditions for its establishment are met.

Investors holding interests in the main class at the designation date receive a corresponding allocation to the side pocket class, expressed as a separate token type at the smart contract level. Each investor's wallet holds two tokens: the main class token, which continues to be valued and traded on the fund's normal cycle, and the side pocket class token, which is valued separately and is subject to its own redemption restrictions.

The administrator maintains the official register with both classes recorded against each investor, the smart contract enforces transfer restrictions specific to each class, and the offering memorandum sets out the conditions under which the side pocket class is valued, traded, and ultimately distributed or wound down. This model is operationally efficient where the side pocket is an occasional rather than persistent feature of the fund's life, and where the strategy lends itself to single-vehicle administration.

Model Two: SPC Side Pocket Portfolios

The second implementation model uses a segregated portfolio company structure, with the side pocket established as a separate segregated portfolio within the SPC. The SPC structure provides statutory segregation between portfolios under the Companies Act of the Cayman Islands, with the assets and liabilities of each portfolio legally separated from those of every other portfolio.

An investor in the main portfolio is allocated participating shares in a side pocket portfolio when the conditions for designation are met, with the side pocket portfolio holding the affected positions and the main portfolio continuing to operate with its remaining assets. Each portfolio issues its own class of tokenized interest, with the smart contract enforcing transfer restrictions specific to that portfolio's tokens, and the administrator maintaining the register at the portfolio level.

This model is operationally more complex than the class-based model but offers stronger statutory segregation between the side pocket and the main portfolio. It is the appropriate structure where the strategy involves recurrent illiquid exposures, where the segregation properties of an SPC are relied upon for additional reasons, or where the platform's operating model is built around segregated portfolios in any event.

The Design Principles That Apply Across Both Models

Smart Contract Considerations Specific to Side Pockets

The smart contract architecture of a tokenized fund must accommodate the issuance, transfer restriction, and cancellation of side pocket tokens. Three design points are worth highlighting.

First, side pocket tokens are typically subject to stricter transfer restrictions than main class tokens. Where the main class permits secondary transfers between whitelisted wallets subject to AML controls, the side pocket class may permit only transfers in defined circumstances, such as transfers required by the redemption of an investor's main class interest, or transfers specifically approved by the board. The smart contract enforces these stricter restrictions automatically.

Second, the redemption mechanics for side pocket tokens are different from the main class. The side pocket token is not redeemable on the fund's standard redemption cycle; it is realised through distributions made by the fund as the underlying positions are liquidated, at which point a portion of the investor's side pocket tokens are cancelled and the corresponding cash distribution is made. The smart contract must be designed to support this partial-cancellation distribution model.

Third, the relationship between the main class and the side pocket class is governed by the constitutional documents and the smart contract's design must reflect that governance. Where an investor redeems their main class holding, their side pocket holding is not affected; the side pocket continues to be held and is realised on the side pocket's own timeline. The smart contract must enforce this independence.

Disclosure and ODD Considerations

The offering memorandum disclosure on side pockets is read carefully by allocators conducting ODD. The expected disclosure addresses the constitutional authority for side pocketing, the criteria for designation, the allocation methodology, the valuation basis, the redemption and realisation framework, and the smart contract enforcement of the relevant restrictions. Where the fund's strategy is one in which side pocketing is foreseeable, the disclosure should address that probability directly rather than presenting side pocketing as a remote contingency.

The principles set out in our analysis of daily NAV for crypto funds apply to the main NAV calculation, with the side pocket NAV operated as a separate workstream under documented procedures. The framework set out in authority architecture for crypto fund governance applies to the board's decision to designate, value, and ultimately close a side pocket, with the authority matrix specifying who may initiate and who must approve each step.

The CV5 Capital Approach

CV5 Capital provides the Cayman regulated infrastructure for digital asset strategies where custody, wallet governance, exchange onboarding, and board oversight are central to investor confidence. The platform operates an SPC architecture that supports the segregated portfolio model for side pockets where required, and the fund tokenization capability is built to support both class-based and portfolio-based side pocket implementations within the digital asset fund platform. The constitutional documents, offering memorandum, and operational procedures are designed to deliver side pocket capability that allocators can assess against institutional standards.

Key Takeaways

• Side pocketing is the established mechanism through which open-ended funds ring-fence illiquid or hard-to-value positions, preserving the economic interest of investors who hold those positions and protecting subsequent subscribers from exposure to assets they did not subscribe for.
• The two principal implementation models in a tokenized Cayman fund are class-specific side pocket tokens within a single vehicle, and segregated portfolio side pockets within an SPC structure. Both are coherent; the choice depends on strategy, investor base, and operational complexity.
• Side pocket implementation requires constitutional authority, board approval, documented criteria, allocation methodology, separate valuation, realisation and distribution mechanics, and transparent disclosure.
• The smart contract architecture must accommodate stricter transfer restrictions for side pocket tokens, partial-cancellation distribution mechanics as positions are realised, and the independence of the side pocket holding from the main class redemption cycle.
• Side pocket disclosure in the offering memorandum is read carefully by allocators conducting ODD. Where side pocketing is foreseeable, the disclosure should address it directly rather than as a remote contingency.
• CV5 Capital's SPC architecture and fund tokenization capability support both class-based and portfolio-based side pocket implementations under board governance, with documentation and procedures designed for institutional ODD.