Side Pockets in Cayman Hedge Funds: Governance and Investor Treatment

Cayman fund side pockets separate illiquid or hard-to-value investments from the liquid portfolio, usually by converting part of each existing investor's shares into a non-redeemable class that participates only in those assets until they are realised. No Cayman statute regulates side pockets as such; they rest on the fund's articles and offering document, and on CIMA's valuation, disclosure and governance rules.

Key takeaways

• A side pocket is a contractual mechanism built into the fund's constitutional and offering documents, usually as a separate class or series of shares.
• The Companies Act permits redeemable shares and redemption on terms authorised by the articles, which may let the directors determine the manner and terms.
• CIMA's rules require a written NAV calculation policy disclosed in the offering document, priority to observable inputs for hard-to-value assets, and annual operator review of the policy and pricing models.
• Material changes to a regulated mutual fund's offering document must be filed with CIMA within twenty-one days of a promoter or operator becoming aware of them where there is a continuing offering.
• The board, not the investment manager, decides whether an asset enters a side pocket, and it should record conflicts and reasons in the minutes.

What a side pocket is and why funds use one

Hedge funds offer periodic liquidity on the assumption that the portfolio can be valued and sold. When a position becomes illiquid, for example a private stake, a restructured claim, a suspended listing or a locked token allocation, two problems follow. Redeeming investors would be paid on a value that cannot be tested by a sale, and remaining investors would be left with a growing share of the illiquid asset.

A side pocket addresses both. The illiquid asset is allocated to a separate class or series. Investors who hold shares when the side pocket is created participate in it pro rata; investors who subscribe later do not. The side pocket interest is not redeemable at the investor's option. When the asset is realised, or the board decides it can be valued and returned to the main portfolio, the side pocket shares are redeemed or converted back.

Side pockets sit alongside other liquidity tools: gates, suspensions of dealing, redemptions in kind and transfers to a liquidating vehicle. They are not interchangeable. A suspension stops all dealing; a side pocket isolates specific assets and lets dealing continue in the rest of the portfolio.

The legal basis in a Cayman fund

Most Cayman hedge funds are exempted companies, and the side pocket class is created under the company's articles. Section 37 of the Companies Act (2026 Revision) allows a company, if authorised by its articles, to issue shares that are to be redeemed or are liable to be redeemed, to vary share rights so that shares become redeemable, and to redeem in the manner and on the terms authorised by the articles or by a resolution. The articles or resolution may authorise the directors to determine the manner and terms of redemption.

In practice, the articles of a fund that may use side pockets provide for:

• a separate class or series of designated investment shares, with defined rights to the assets allocated to it;
• the directors' power to designate investments and to convert a proportion of each investor's participating shares into the side pocket class;
• the non-redeemable status of side pocket shares and the events on which they are redeemed or converted back; and
• how fees, expenses and any borrowing are allocated between the main portfolio and each side pocket.

Each conversion changes the register of members, which must record the number and category of shares held by each member and whether each category carries voting rights. Our guide to master-feeder fund structure and governance explains how the mechanism is mirrored where a feeder invests through a master fund.

Segregated portfolios as an alternative

A segregated portfolio company can hold illiquid assets in a separate portfolio with statutory segregation of assets and liabilities. That is a different tool from a side pocket class, and it is normally chosen at formation. Our guide to Cayman segregated portfolio company formation covers when the SPC route suits a manager.

Disclosure: what the offering document must say

CIMA's Rule on the Contents of Offering Documents for regulated mutual funds requires the offering document to describe, among other things, the procedures and conditions for redemption and the circumstances in which redemption may be suspended, the principal rights and restrictions attaching to the equity interests, the fund's material risks, its NAV calculation policy, the remuneration of the operator and service providers, and potential conflicts of interest. Where a fund intends to use side pockets, those headings are where the mechanism, its effect on liquidity and its fee treatment should be explained.

The Rule also requires a statement confirming the power to enter into side letters that give an investor more favourable redemption terms than other holders of the same class. Side letters granting priority exit from, or exemption from, side pockets raise exactly that issue and should be considered by the board before they are signed.

If a fund adds a side pocket power after launch, the change is likely to be material. Section 4 of the Mutual Funds Act (As Revised) treats a fund with a continuing offering as not having a current offering document on file if a promoter or operator is aware of a change that materially affects the information filed and has not filed an amended offering document within twenty-one days of becoming aware. Adding the power may also require a variation of class rights under the articles, with the investor approvals the articles specify.

Valuation of side pocket assets

Moving an asset into a side pocket does not remove it from valuation. CIMA's Rule on the Calculation of Asset Values for regulated mutual funds requires a written NAV calculation policy, disclosed in the offering document, that ensures the NAV is fair, complete, neutral, free from material error and verifiable. NAV must be calculated at least quarterly. The policy must give priority to unadjusted market prices and, for hard-to-value securities, to observable inputs, with unobservable inputs given the lowest priority. Pricing models must be calibrated to the extent appropriate to address the risk of material error.

The Rule also requires the NAV to be calculated by a service provider independent of the investment manager and operators, subject to stated exceptions, and requires the offering document to disclose any material involvement of the investment manager in pricing and the resulting conflicts. Side pocket assets are often the ones the manager knows best and the administrator can verify least, so the policy should state who proposes a value, what evidence supports it and who approves it. A parallel rule applies to registered private funds. Our board-level guide to hedge fund valuation policies sets out the wider framework.

Governance: decisions the board owns

The operators, meaning the directors of a fund company, have ultimate responsibility for oversight of the entire valuation process and must approve and review the NAV calculation policy and any pricing models at least annually. CIMA's Statement of Guidance on corporate governance for mutual funds and private funds expects operators to monitor whether the NAV is calculated in accordance with the policy, to maintain a written conflicts of interest policy, and to record disclosed conflicts in the minutes of the meeting at which a matter is decided.

For side pockets, that translates into a short list of decisions that should be taken and minuted by the board:

• Designation. Whether a specific asset meets the criteria in the documents, on a written recommendation from the investment manager that explains why it cannot be valued or sold on normal terms.
• Conflicts. Whether the manager's fee position changes because of designation, for example where a management fee is charged on a different basis or a performance fee is deferred, and how that conflict is managed.
• Valuation. The initial carrying value, the basis for it and the review frequency, consistent with the NAV calculation policy.
• Investor communication. What investors are told on designation, in periodic reports and on realisation.
• Exit. When the asset is realised or returned to the main portfolio, and how proceeds are distributed or reinvested.

Our note on CIMA's fund governance guidance covers the meeting and minute expectations in more detail.

Investor treatment

Side pockets are fair only if they are applied as the documents describe. Every investor holding shares at the designation date should participate pro rata, and the conversion and later redemption should be recorded promptly. Investors who redeem from the main portfolio while a side pocket is open typically retain their side pocket shares until realisation, so the fund continues to owe them reporting and, at the end, their share of proceeds. Long-dated side pockets are a common subject of operational due diligence, and directors should be ready to explain each one to allocators.

Frequently asked questions

Does CIMA approve the creation of a side pocket?

There is no separate CIMA approval for side pockets in the rules reviewed here. A regulated mutual fund must, however, keep its offering document current and file an amended document within twenty-one days where a material change requires it.

Can a Cayman fund create a side pocket if its documents do not provide for one?

Only by amending its documents. The articles must authorise the class, the conversion and the redemption terms, and any variation of existing class rights must follow the procedure and investor approvals in the articles.

Are side pocket assets still included in the audited financial statements?

Yes. The side pocket is part of the fund, and its assets are valued under the NAV calculation policy, which must be consistent with the accounting principles used for the audited financial statements.

Who decides the value of a side pocket asset?

The NAV is calculated by an independent service provider in line with the policy, with any manager involvement disclosed. The board has ultimate oversight and approves the policy and pricing models.

Where Bell Rock fits

Bell Rock Group Financial Services Limited is licensed by the Cayman Islands Monetary Authority as a Company Manager under the Companies Management Act (As Revised), Licence No. 633916. Through its Cayman fund formation service, Bell Rock prepares board papers and resolutions for side pocket designations, records class conversions in the register of members and coordinates offering document filings with CIMA. Independent directors appointed through Bell Rock act in their personal capacity.

Related reading

• Cayman fund directors: duties and appointment criteria
• Cayman fund audit requirements and extensions
• Private credit funds: structuring and governance
• Fund Board Minutes and Meeting Practice in the Cayman Islands
• When to Use a Cayman Segregated Portfolio Company (SPC)
• Independent Directors: What Allocators Expect from Cayman Fund Boards

Bell Rock structures new funds and amendments through its Cayman fund formation service.