Side Pockets in Crypto Funds: When and How to Use Them

Side pockets are a standard tool in alternative fund management for isolating illiquid or hard-to-value positions from the fund's main liquid portfolio. In digital asset funds, the case for side pocket provisions is particularly strong given the frequency with which strategies encounter positions that become illiquid through lock-up mechanisms, protocol-level constraints, exchange failures, or regulatory freezes. Understanding when side pockets are appropriate, what documentation they require, and what governance obligations they create is essential before a fund encounters a situation where they are needed.

"Side pockets are not a sign that something has gone wrong. They are a mechanism for ensuring that remaining investors are not disadvantaged by the illiquidity problems of a specific position, and that redeeming investors receive fair treatment relative to the value of what they hold. A fund that has side pocket provisions correctly documented in its offering memorandum is a fund that has thought carefully about what happens when the portfolio does not behave as expected." David Lloyd, Chief Executive Officer of CV5 Capital

What a Side Pocket Actually Is

A side pocket is a segregated portion of a fund's portfolio used to hold a specific position or group of positions that have become illiquid, hard to value with confidence, or subject to a restriction that prevents their inclusion in the main NAV calculation on standard terms. When a position is transferred to the side pocket, new investors cannot subscribe into it, redeeming investors receive their liquid portfolio redemption proceeds but cannot redeem the side pocket interest, and management and performance fees on the side pocket position are typically not charged until the position is realised.

The rationale for side pockets is investor fairness. Without a side pocket mechanism, a fund that cannot liquidate a specific position faces a choice between paying redeeming investors with proceeds from liquidating other positions (which disadvantages remaining investors by forcing the sale of assets not designated for redemption) or delaying all redemptions until the illiquid position resolves (which disadvantages redeeming investors by preventing them from accessing the liquid portion of their holding). The side pocket allocates the illiquidity problem to the investors who were exposed to it at the time of its creation, rather than spreading it across the investor base indiscriminately.

When Side Pockets Are Appropriate in Crypto Funds

The scenarios in which a side pocket is the appropriate response in a digital asset fund include positions subject to exchange withdrawal freezes or insolvency proceedings, token positions subject to vesting schedules or protocol-level lock-ups that were not anticipated at the time of investment, on-chain positions locked in protocols pending governance votes or technical resolution, tokens subject to regulatory freeze or legal dispute that prevents transfer, and positions in protocols or issuers that have suspended operations but where a residual recovery value may exist.

Each of these scenarios requires a board resolution creating the side pocket, a contemporaneous valuation of the position being transferred, an investor notification meeting the requirements of the fund's offering memorandum, and a documented basis for the board's decision. The creation of a side pocket is a material event that must be reported to CIMA under the fund's notification obligations and must be reflected in the fund's financial statements for the relevant period.

What the Offering Memorandum Must Say Before a Side Pocket Is Created

The critical point about side pockets is that the authority to create them must be established in the fund's offering memorandum before the need arises. A manager who attempts to create a side pocket without offering memorandum authority is making a unilateral modification to investors' redemption rights that is not authorised by the fund's constitutional documents. This is both a governance failure and a potential basis for investor claims.

The offering memorandum provisions governing side pockets must specify the conditions under which the board may designate a position for side pocket treatment, the valuation methodology that will apply to side pocket interests, the fee treatment during the side pocket period, the conditions for and procedure governing realisation of side pocket interests, and the investor notification requirements applicable to each of these events.

For managers who have not yet launched, including side pocket provisions in the offering memorandum at launch is straightforward and has minimal cost. For managers who have launched without side pocket provisions and who now face a situation where they are needed, the options are constrained. Adding side pocket provisions to an existing fund typically requires investor consent and involves both legal costs and investor relations management. The lesson for pre-launch managers is to include side pocket provisions regardless of whether the strategy is expected to generate positions requiring them. The option value of having the mechanism available is high, and the cost of including it at launch is negligible. The CV5 Capital digital asset fund platform offers documentation frameworks that include side pocket provisions as a standard component of the offering document template.

Key Takeaways

• Side pockets isolate illiquid or hard-to-value positions from the main portfolio, ensuring that redeeming investors receive fair treatment and that remaining investors are not disadvantaged by the liquidation of assets to fund redemptions for an illiquid position.
• The authority to create side pockets must be established in the offering memorandum before the need arises. A side pocket created without offering memorandum authority is an unauthorised modification of investor redemption rights.
• Side pocket creation requires a board resolution, contemporaneous valuation, investor notification, administrator update, and potentially a CIMA notification. Each step must be completed in the order and within the timeframes specified in the offering memorandum.
• Digital asset funds face a wider range of potential side pocket triggers than traditional funds, including exchange withdrawal freezes, protocol lock-ups, regulatory freezes, and on-chain governance constraints. Including side pocket provisions at launch is standard practice for any strategy with exposure to these risks.
• Adding side pocket provisions to an existing fund after launch requires investor consent and is significantly more complex and costly than including them in the offering memorandum from the outset.