With multiple years of global catastrophes particularly in 2017 and 2018 which included the California wild fires, Hurricane Florence, Harvey, Irma, Typhoon Jebi, and Hato, Insurance Linked Securities (“ILS”) such as fully collateralized insurance-linked contracts held by many ILS Funds are subject to significant losses from multiple covered events. These loss events have resulted in trapped collateral which occurs when loss impacted investments are placed into side pockets for open ended funds. This effectively traps the collateral relating to the loss impacted investment from being redeployed into new ILS investments until the ultimate loss can be quantified which can take months and sometimes years depending on the complexity of the loss event. This presents many challenges in administering ILS funds as the quantification of such losses is highly uncertain which creates valuation and liquidity issues impacting investors and ILS managers. Expert service providers including legal counsel, auditors, and fund administrators who understand the specific idiosyncrasies are important in structuring new operationally effective funds and subsequently navigating the Fund through these challenging times, whilst allowing investors to gain comfort that they are being treated appropriately and equitably.

Side Pocket Considerations
In order to achieve both fairness amongst both investors and the ILS managers it may be necessary to segregate the loss or highly probable loss impacted investments from the non-loss impacted investments with the use of side pockets. These ring-fenced assets are separated from the remaining assets at the discretion of the Board of Directors of the Fund in order to protect shareholder interest.

When a loss event occurs that may potentially impact ILS investments, the Directors of the Fund should consult with their advisory team and consider whether it is prudent to designate an investment as a “side pocket investment” prior to the Fund’s valuation date. The Directors should consider factors such as the existence of any capital activity event associated with the Fund, the materiality of the potential loss, the availability of third party marks, the degree of uncertainty of the event parameters including historical accuracy of loss estimates, sensitivity of the loss to changes in estimates, the ability to remodel the losses, and the length of the loss development period for the underlying risk. The constitutional or governing documents of the fund must be reviewed to ensure appropriate operating mechanics are followed during the designation of investments and the creation of the side pocket.

It is important for the Directors to consider loss impacted investments particularly if there are capital transactions, as this will have a material bearing on the need to side pocket an investment. New subscriptions should not participate in any prior loss impacted investments unless these can be accurately valued and entry into the Fund should be based on the fair value of the remainder of the Fund’s non-impacted loss investments. Similarly, for redemptions it is important that redeeming investors ultimately receive redemption proceeds that reflect the true fair value of their redeemed shares which is problematic when there is significant loss impacted investments that are difficult to objectively value.

Side Pocket Mechanics
To ensure all new, existing, or redeeming investors are treated fairly a pro-rata portion of existing investors’ series of shares in one class (ordinary shares) are converted into a new class of series of shares (side pocket shares) corresponding to the value of side pocket investments at the most recent valuation date. This effectively segregates the loss impacted investments from the non-loss impacted investments within the portfolio for accounting purposes and any increases or decreases in the value of a particular side pocket investments will be separately accounted for in these side pocket class of shares. As the side pocket investment valuation is initially uncertain the side pocket shares will not be redeemable until the respective side pocket investment is realized or the valuation becomes certain (for example the insurance entity enters into a commutation agreement) as determined by the Directors in consultation with their advisory team. Once this valuation event is identified and the side pocket investments are deemed realized than the side pockets shares are converted back to their original class of ordinary shares consistent with the release of collateral from the trust account and these shares are eligible for redemption in line with the terms of the Fund.

Side Pocket Complexities
Complexities arise when some Investors wish to redeem their shares while there are loss impacted investments in the Fund’s underlying portfolio. One alternative is to pay the redeeming investors a portion of the cash proceeds based on the investor’s proportionate share of non-loss impacted investments and issue a new class of shares (redemption shares) for their proportionate share of loss impacted investments. These class of shares are only redeemed, and cash proceeds paid once the underlying loss impacted investments are realized or deemed realized. Therefore, the holder of these class of shares fairly continue to bear the risk of performance of the applicable loss impacted investments and do not disadvantage the existing investors.

When an investor entirely redeems out of the Fund and leaving the investor with only side pocket shares, consideration must be given to how a side pocket’s applicable share of future expenses is paid, allocated, and accounted for. One solution could be the issuance of Expense Shares whereby a portion of the investor’s proceeds are held as a reserve for future payment of expenses and are issued a separate class of shares which facilitates reporting to the investor. As expenses are incurred, its proportionate share of expenses is allocated to this class and shares are periodically redeemed when the fund expenses are paid by the Fund.

The creation of side pocket shares also impacts the calculation of management fees and performance fees which are based on the valuation of the underlying investments or based upon the net profit or loss earned on the underlying investments. The challenge here is that the valuation ascribed to the side pocket investment at each valuation date may differ significant from the value at which it may ultimately be realized which complicates the calculation of asset based and income-based fees. This is where the adopted policies for both fee calculations needs to be weighed against the interest of the investor and the manager.

Best Practice Recommendations
Krypton Fund Services (Bermuda) Ltd (“Krypton”), a newly launched boutique fund services company that offers a high touch customized administration service to its clients and is licensed by the Bermuda Monetary Authority under the Investment Funds Act 2006, believes that side pockets are a critical component to be considered when the Fund is being structured. This is especially true when the Fund invests into potentially “hard to value” securities. Krypton recommends the following to ensure investors and the manager’s interest are fairly protected;

• Planning and documentation. Krypton recommends that throughout the drafting of the Fund’s offering documentation it is critical to assess all potential events and incorporate the corresponding operating mechanisms into the documents. In addition, it is critical to have the Fund’s administrator and auditor involved in the process as their expertise gained through past experience is invaluable in developing best practices that can be incorporated into the Fund’s offering documentation. Proper documentation, structuring and knowledge at the drafting phase will minimize issues when and if these mechanisms need to be enacted.
• Documentation review. The Fund’s constitutional documents should be reviewed periodically to ensure the documents still reflect the original intent and objectives of the Fund and the interest of the investors.

Timely communication. Sophisticated investors who invest in asset classes with potential liquidity issues appreciate timely and transparent communication outlining when these mechanisms will be utilized. The Fund’s administrator will be able to assist in this process.

About Krypton Fund Services
Krypton Fund Services (‘Krypton’) is a new boutique fund services company with a sole purpose of providing Excellent Client Service. The core focus of our business is Client focused with service and accountability as the framework of everything we do. We pride ourselves on a very client-centric approach that is not a cookie cutter offering.
Our platform provides regulatory reporting, fund administration, registrar and transfer agent, project management and setup, to a wide range of family office investment portfolios, investment funds, private and special purpose vehicles operating predominantly in the alternative investment arena.

Contact information:
Roderick White, CEO
Email: rwhite@kryptonfs.com
Suite No. 1222
Rosebank Centre
11 Bermudiana Road
Pembroke, HM08
Bermuda