Next in our “Hedge Fund Investment” series…

The complex nature of hedge fund investing has inspired volumes of theoretical explanation on the directional nature of investing and event-driven strategies.  Warren Buffett himself has devoted much attention to the topic.  Arbitrage and equity markets and risk parity are buzzwords that economists use when debating the merits of hedge funds.

In the hedge fund paradigm, investments that lack liquidity are place into a separate account by the hedge fund manager, known as a “side pocket account.”  In essence, this investment is tracked separately from the other investments in the fund.  Provisions for side pocket investments are established in the offering documents for the fund.  A limit is usually placed on side pocket investments, based on a percentage of the total assets of the fund.

So what do side pockets have to do with hedging real estate?  Everything…

An investor who chooses to withdraw from a hedge fund cannot receive any portion of an asset held in a side pocket account nor can he force the manager to sell an asset held in a side pocket.  If the property must be held for a variety of reasons to stabilize value, this will prevent the asset from having to be sold before the fund is able to realize the full potential value of the property.  The departing investor will be paid out on the side pocket asset at such time as the asset is liquidated.

In the real estate hedge fund, it is often a reality that a piece of property cannot be accurately valued or is not currently liquid for some reason.  The hedge fund manager is paid based on the valuation of investment, using a side pocket account will prevent the overvaluation of a property and the subsequent overpayment to the manager.

A word about valuation…  when hedging real estate, the investor must remember that there is not an easy liquid exchange methodology for real estate (unlike securities, bonds, or other assets that are more traditionally liquid).  Valuation is a critical part of real estate hedge funds, and this is where many funds got out of hand in the mid 2000s.  Consequently, side pocket assets are a cleaner method of approach unless the fund does not allow for withdrawals or the payment of performance fees until there is a disposition event.  Various methods of valuation are used when hedging real estate, depending primarily on the nature of the property.  We will discuss these in a future article.

Next up, costs and fees involved with hedging real estate… 

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NOTE:  We pride ourselves on bringing you the most informative, up-to-date, and accurate information possible about the often-confusing world of real estate investing.  Nothing we post however is intended to be taken as legal advice.  You should always contact a licensed legal professional for information and advice about your own unique investment scenarios.

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