The Securities and Exchange Board of India (SEBI) established a framework called side pocketing in December 2018, amidst the IL&FS fallout. The failure of IL&FS to fulfil its obligations to creditors and lenders severely affected the net asset value of numerous debt funds holding IL&FS group papers. SEBI’s response was the creation of the side pocketing framework, a strategy that allows mutual funds (MFs) to separate bad assets onto a distinct portfolio within their debt schemes.
The Basics of Side Pocketing
Side pocketing serves as a safety measure that protects retail investors from risky investments. It provides MFs with permission to split stressed assets from high-quality liquid assets. This segregation is triggered when a debt instrument is downgraded to a default rating by credit rating agencies. In such a situation, MFs can opt to create a side pocket, which safeguards good assets by ring-fencing them.
All existing investors in the scheme will be offered an equal number of units in the segregated portfolio as they hold in the main portfolio. However, no redemptions or subscriptions are permissible in this partitioned portfolio.
Listing and Price Discovery
The segregated units must be listed on a stock exchange within ten days, which grants an exit route for the unit holders. Not only does this facilitate price discovery for the beleaguered assets, but it also gives investors the liberty to sell at the current price or wait for potential recovery in the future.
| Aspect | Description |
|---|---|
| Side Pocketing Introduced | December, 2018 |
| Purpose | Segregation of bad assets from good ones within debt schemes |
| Trigger | Default rating by credit rating agencies |
| Result | Creation of a separate portfolio that needs to be listed on stock exchange within 10 days |
Misuse and Regulation
Fundamentally, side pocketing can serve as a shield for MFs to conceal their poor investment decisions. Acknowledging this potential pitfall, SEBI has implemented checks and balances to prevent misuse.
Trustees of all fund houses are obliged to enforce a framework that detrimentally affects the performance incentives of fund managers, chief investment officers (CIOs), and others involved in the investment process of securities under a segregated portfolio.
Moreover, SEBI has underscored that side pocketing is not an endorsement of undue credit risks, and any abuse of this option would be viewed seriously with stringent consequences. It ultimately serves as a tool designed to protect investor interests during times of financial strain or instability.
