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Side Pockets and Performance Fees: What Happens When Assets Become Illiquid?
A position that was liquid when it was bought can become illiquid overnight: an exchange fails, a credit instrument is written down, a token stops trading. The moment a holding can no longer be reliably valued or sold, two fairness problems appear at once. Should the manager charge a performance fee on an uncertain mark? And how should redeeming and remaining investors share the position? The side pocket is the mechanism designed to answer both.
"The danger with an illiquid position is paying a performance fee on a number that later turns out to be fiction. A side pocket freezes that position, stops fees crystallising on a guess, and makes sure the investors who owned it bear its outcome."Jason Eastman, Director at CV5 Capital
Why This Matters
Recent market stress, from exchange failures to written-down credit instruments and distressed claims, has repeatedly shown what happens when funds carry hard-to-value positions through their NAV. Without a side pocket, a manager might crystallise a performance fee on a position later marked to near zero, and redeeming investors might exit at a price that unfairly burdens those who stay. A side pocket prevents both, and is a core part of the liquidity toolkit alongside redemption suspensions.
The Common Misunderstanding
The misunderstanding is that a side pocket is a sign of failure or an attempt to trap capital. Used properly it is the opposite: a fairness mechanism that protects investors from paying fees on illusory gains and from cross-subsidising each other's exits. The abuse is not the side pocket itself but the side pocket applied without independent valuation or clear rules, which is why governance matters as much as the tool.
The Practical Reality: How a Side Pocket Affects Fees
| Step | Effect |
|---|---|
| Position side-pocketed | Illiquid asset moved out of the main NAV into a designated class or account |
| Performance fee | No performance fee crystallises on the side-pocketed asset until it is realised |
| Redemptions | Redeeming investors keep their share of the side pocket until it resolves |
| Resolution | On realisation, gains or losses and any fee are recognised based on the actual outcome |
CV5 Insight
A side pocket only protects investors if its valuation is independent and its rules are written down in advance. The mechanism is sound; the failures come from manager-controlled marks and vague documentation.
Key Considerations
- Independent valuation. The side-pocketed asset must be valued independently per the valuation policy, not by the manager.
- No fee on the unrealised mark. Performance fees should crystallise only on realisation, consistent with the high water mark logic.
- Clear allocation. Document how redeeming and remaining investors share the position.
- Disclosure. Side-pocket terms must be in the offering memorandum, a point allocators probe in the fund-of-funds context.
How the CV5 Platform Model Helps
CV5 Capital is a Cayman Islands-based regulated fund platform supporting hedge fund and digital asset fund launches through CV5 SPC and CV5 Digital SPC. The platform's independent directors and administrator govern how side pockets are created, valued and unwound per the offering memorandum, so the mechanism protects investors rather than being controlled by the manager. CV5 provides the governance and operating framework; the manager retains investment discretion within it.
Risks and Caveats
Side-pocket mechanics and their interaction with performance fees are governed by the fund documents and should be drafted with counsel and applied with independent valuation. A side pocket does not recover value from a failed position; it allocates the outcome fairly. Nothing here is investment, legal or tax advice.
Key Takeaways
- A side pocket freezes an illiquid position so fees and redemptions stay fair.
- No performance fee should crystallise on a side-pocketed asset until it is realised.
- Redeeming investors keep their share of the side pocket until it resolves.
- Independent valuation and clear documentation are what make it protective, not abusive.
Structuring for Illiquidity Risk?
CV5 Capital can help build side-pocket and valuation governance so a fund handles illiquid positions fairly. Speak with our team about your structure.
Visit cv5capital.io/fund-manager-formation to learn more.
Speak With CV5 CapitalFrequently Asked Questions
What is a side pocket?
A side pocket ring-fences an illiquid or hard-to-value position from the main portfolio so that subscribing and redeeming investors are treated fairly and fees are not charged on an uncertain mark.
Are performance fees charged on side-pocketed assets?
They should not crystallise until the position is realised. Charging a performance fee on an unrealised, uncertain mark is exactly the unfairness a side pocket is designed to prevent.
Is a side pocket bad for investors?
Not when used properly with independent valuation and clear rules; it protects investors from paying fees on illusory gains and from cross-subsidising exits. The risk is manager-controlled marks. See our complete guide to side pockets and the full CV5 Capital Insights library.
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