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SEBI allows side pocketing in Mutual funds- this is how it works?
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SEBI in its board meeting today allows sidepocketing in debt and money market mutual funds to segregate bad / illiquid assets
 
The concept of a side pocket is as follows:
 
1) If you have a 100 crore fund at Rs. 100 NAV (1 crore units) and about 5 crore is bad, then you have to value the 5 crore at something
 
2) If you value it at say 3 crore. at say 40% haircut then NAV becomes 98. Now you have a problem. Because then let's say 75 crore worth exits happen at Rs. 98 NAV = 76.5 crore units. You have to sell the good stuff because the bad stuff isn't sellable. So you sell it. You're now left with 20 crore of good stuff and 3 crore worth of the bad stuff. The remaining holders are now sitting with nearly 20% exposure to bad stuff which was only 5% earlier and if more exit then the remaining people are left holding the bad assets.
 
3) So lets say you value at 0. Then NAV falls to 95, but then people pile on, thinking look they will at least recover 2 crore. eventually so one will get a 2% bump on my NAV when they do. Then you give them fresh units but that screws up existing holders who will not recover much. For example if another 95 crore comes piling on, then you have 190 crore of AUM plus 5 crore of the bad stuff. This is now only 2.5% and any recovery of 2 crore will bump up the NAV by only 1%. Your old unit holders lost 5% when you marked down to zero, but on the way up when you recovered Rs. 2 they got back only 1%.
 
4) So many funds do this: they value at zero and disallow any new shareholders from entering. This way they retain sanity on steps (2) and (3) here.
 
5) But this is nonsense because the fund gets no more AUM. That will also be a problem eventually.
 
6) So, the idea of a side pocket. How does that work?
 
7) You put the 5 crore into a separate fund called F2, or the side pocket. Your original fund F has an AUM of 95 crore and NAV becomes 95. All unit holders get equivalent units of fund F2 which has an NAV of Rs. 5 which has ONLY the bad stuff, and that fund doesn't allow buyers and redemption too are not allowed until recovery happens.
 
8) The main fund F continues to accept new subscriptions. The sidepocket has no entries or exits until recovery.
 
In the light of ILFS kind of situation recently, many funds have to take the hit on their NAVs. This will help MFs to segregate those assets.

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