[The following guest post is contributed by Pavit Singh Kochar, an advocate practicing in New Delhi]
A popular concept abroad that is yet to be practised extensively in India is a “Side-Pocket”, which means the segregation of the portfolio or funds to separate the illiquid investments from the more liquid assets in the portfolio. This concept is used when a part of the portfolio is not performing well and the entire portfolio should not suffer because of it.
In a first in the history of the Indian mutual fund industry, JP Morgan Asset Management (India) Pvt. Ltd (“JPM”) has proposed to carve out affected portions of its portfolio by creating a side-pocket for its two schemes: JP Morgan India Short Term Income Fund (“STIF”) and JP Morgan India Treasury Fund (“TF”) into a separate units.
The process followed for a side-pocket is that the scheme consists of number of units which are held by the investors. These units in an existing scheme shall be split into two different parts and different units will be allotted to the investors in a pro-rata basis for representing the respective parts of the portfolio. The main purpose for such segregation is to ensure that the overall portfolio should not suffer due to small portion of illiquid investments in the portfolio.
Impact on the Investors by the Creation of a Side-Pocket
When a side-pocket is created in the overall portfolio, existing investors who were holding units in such overall portfolio will now be allotted units in two holdings on a pro-rata basis. The profits and losses derived from such side-pocket concept are allocated solely to the existing investors in fund during the segregation. Since the assets in the portfolio are split between various holdings, the Net Asset Value of the portfolio will be reduced and transferred to the other units.
Investors tend to resist the use of side-pocket schemes because the redemption of their invested capital becomes more restricted. When a side-pocket is used, an investor is compelled to retain that portion of its capital in the fund even if the investor has otherwise decided to sell the units. This makes it difficult for the investor to determine whether it will gain or suffer losses on its overall invested capital.
Apart from the above risk, the investor also gets the opportunity to earn regular liquidity from the good investments even though a small portion of its invested capital is affected. The units representing the illiquid investment may yield profits when the investment is redeemed or sold.
In the JPM case, the company has obtained the necessary majority approvals from the holders of STIF and TF to segregate the assets of these two schemes. The segregation was approved on account of the investment by STIF and TF in Amtek Auto Ltd turning sour. Post segregation, one set of units will represent the investments in Amtek Auto Ltd. and another set of units will represent all the other investments and cash holdings.
The side pocket should be exercised diligently and executed properly to help level the playing field for investors in a fund which is experiencing liquidity issues. Creating a side-pocket is not a simple solution for a difficult problem and various operational and ethical issues must be considered before creating one.
- Pavit Singh Kochar