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SBAI sets out ILS side-pocketing guidelines

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The Standards Board for Alternative Investments (SBAI) has produced a memo on ILS side-pocketing practices that it said should help to improve outcomes for asset managers and investors.

The recommendations include establishing side pockets as quickly as possible after an event, prominently disclosing side-pocket performance, and being transparent on the processes and fees attached to side pockets.

The use of side pockets is typically an “investor-friendly practice”, said Albourne Partners senior analyst Michael Hamer.

Side-pocketing is used by ILS managers to isolate assets of uncertain valuation. Typically, this involves creating new share classes after an event to protect new investors entering a fund from picking up claims associated with prior events, and to ensure exiting investors do not gain an unfair advantage.

"[The memo] provides a very useful framework for considering the appropriate alignment of interests between the various groups of investors and asset managers as well as a toolkit for ensuring robust practices and governance of the side-pocketing process,” said Hamer.

Securis COO Paul McCabe agreed that side-pocketing was essential within ILS.

"Given the variation in approaches and importance of transparency and disclosure when operating side pockets and reporting on fund performance, it is vital for the ILS industry that the side-pocket process is effectively governed to create the right outcome for investors and asset managers.”

The SBAI guidelines would help asset managers "review and enhance their side-pocketing processes as well as [listing] important questions that allocators to ILS funds should be asking their external asset managers,” added Lorenzo Volpi, managing partner at Leadenhall Capital Partners.

The memo outlines that side pockets should ideally be created at the time an asset becomes hard to value – which would typically be after a major loss event.

However, generally ILS managers form side pockets when they are looking to raise new funds or redeem investor capital. This allows them to delay the operational burden of creating a side pocket and it can also give more time for valuation uncertainty to settle down.

But the memo pointed out that this tendency to delay has implications for investors' fees – which might be higher on main-fund assets than side-pocketed assets – and the liquidity available to them, which some investors may monitor regularly.

In terms of fees, some managers charge the same fees on a side pocket, as an indicator of the work involved in maintaining the assets, while others offer a discount to reflect the illiquidity of the position.

Each option has a possible disadvantage, in that if side-pocketed assets were returned to investors, this may create an incentive to delay the wind-up; while discounted fees may create an incentive to underestimate losses, and risk losses leaking into the main fund.

“Any management fee structure should both align the interests of the asset manager and the investor and ensure that the side pocket remains in place for as long as it is prudent, but not for an extended period,” the memo outlined. Disclosures should include frequency of payments and treatment of trapped collateral.

The memo also covered instances in which ILS managers are borrowing trapped capital in a side pocket as leverage for their main fund, and recommended that managers should look to complete such transactions on an “arm’s length” basis that may include the main fund paying borrowing fees to the side pocket.

On reporting of side-pocket performance, the memo suggests that managers should report gains for a day-one investor including all main fund and side-pocket performance on both an integrated and split basis.

Where reporting main fund and side-pocket performance separately, the side-pocket performance should ideally be given as much prominence as the main fund rather than being hidden in footnotes.

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