The SEC brought another case against a private investment fund for misuse of side pockets. Lawrence R. Goldfarb of Baystar Capital Management agreed to pay a hefty fine to settle claims brought by the Securities and Exchange Commission for misuse of his investment fund’s assets.
When used properly, a side pocket is a mechanism that a hedge fund uses to separate illiquid investments from the liquid investments. If a fund investor redeems their investment in a hedge fund with a side pocket, the investor cannot redeem the pro-rata portion of their investment allocated to the side pocket. That portion of the redemption is delayed until the asset is liquidated or is released from the side pocket. It’s a way to protect all of the investors when the fund has a big chunk of illiquid assets. A wave of redemptions would force the sale of liquid assets, leaving those who did not redeem with the illiquid assets.
The typical abuse is to hide under-performing assets from limited partner scrutiny. The manager still collects the management fee on the over-valued assets. Without recognizing the loss, partners are less likely to redeem their capital.
The SEC complaint alleges that Goldfarb acted even more egregiously than disguising valuations. He stole profits from the fund.
The complaint states that Goldfarb’s fund invested in a real estate partnership. Since that investment was likely a very illiquid asset it would typically end up in a side pocket. Shortly after the investment was made the real estate partnership started making cash distributions. Goldfarb has these distributions sent to him instead of the investment fund. He ended up transferring the whole interest to himself, using the side pocket to hide the asset and the distributions.
At first I thought this might be an interesting action to highlight Rule 206(4)-8. From the complaint, is sounds more like a case of blatant theft from the fund. This enforcement actions shows that the SEC is focusing on private funds, valuations, side pockets and affiliate transactions.
Without admitting or denying the SEC’s allegations, Goldfarb and Baystar Capital Management consented to permanent injunctions against violations of certain provisions of the federal securities laws and to pay disgorgement of $12,112,416 and prejudgment interest of $1,967,371, which will be distributed to the fund’s investors. Goldfarb also agreed to pay a $130,000 penalty, be barred from associating with any investment adviser or broker (with the right to reapply in five years), and be barred from participating in any offering of penny stock.