Side-pocketing introduction in Indian mutual funds (2018)
Side-pocketing, formally termed “segregated portfolio” in Indian regulatory terminology, is a mechanism that allows a mutual fund scheme to separate debt or money market instruments affected by a credit event into a distinct sub-portfolio, ring-fencing the impaired assets from the main portfolio and protecting ongoing investors from dilution by redemption outflows. The mechanism was introduced in India by the Securities and Exchange Board of India through Circular No. SEBI/HO/IMD/DF2/CIR/P/2018/160, issued on 28 December 2018, directly in response to the valuation and fairness challenges exposed by the IL&FS default of September 2018. Side-pocketing had been debated in the Indian mutual fund industry for several years before the Association of Mutual Funds in India recommended its adoption in the wake of the IL&FS crisis.
The problem it solved
Before side-pocketing, when a debt instrument held by a mutual fund scheme suffered a credit event, a default, a rating downgrade to below investment grade, or a regulatory determination of significant credit deterioration, the scheme faced a structural fairness problem:
The first-mover advantage problem: As soon as market participants perceived that a scheme held a stressed instrument, informed investors would rush to redeem at the current NAV, which might not yet fully reflect the impairment (because valuations lagged the news, or because the AMC was awaiting formal rating agency action). Early redeemers exited at artificially elevated NAVs, effectively offloading their share of the impaired asset onto investors who remained. Remaining investors then bore the full write-down when it was eventually recognised, experiencing a larger loss than if all investors had shared the impairment proportionally.
The forced selling problem: To meet redemption requests, the AMC had to sell the performing assets of the scheme (since the impaired instrument was illiquid). This degraded the quality of the remaining portfolio and potentially crystallised losses on assets that would have recovered if held to maturity.
Both problems were empirically demonstrated in the JP Morgan Amtek Auto incident of 2015, where JP Morgan had suspended redemptions as the only available alternative, and in the broader NAV write-down dynamics following the IL&FS default.
SEBI circular: December 2018
SEBI’s circular of 28 December 2018, titled “Creation of Segregated Portfolio in Mutual Fund Schemes”, established the following framework:
Trigger conditions
A segregated portfolio could be created when a debt or money market instrument held by a scheme:
- Was rated below investment grade (below BBB- or equivalent) by a SEBI-recognised credit rating agency, or
- Was in default on scheduled interest or principal payments.
The AMC’s board of directors and the scheme trustees had to approve the creation of the segregated portfolio. Creation was not automatic; AMC discretion was preserved but subject to trustee oversight.
Mechanics of segregation
Upon creation of the segregated portfolio:
The NAV of the scheme was bifurcated: a “main portfolio” NAV (covering all performing assets) and a “segregated portfolio” NAV (covering only the impaired instrument, written down to a value reflecting the credit event).
All existing investors in the scheme received units in both the main portfolio and the segregated portfolio, in proportion to their existing holdings. No existing investor benefited or was disadvantaged relative to any other at the point of bifurcation.
New investors could subscribe to units of the main portfolio (at main portfolio NAV) but received no units of the segregated portfolio, they had no stake in the impaired asset and therefore no claim on any recovery proceeds.
Redemptions from the main portfolio could proceed normally at the main portfolio NAV. Redemptions from the segregated portfolio were not permitted until recovery proceeds were received from the defaulted issuer, at which point distributions would be made to segregated portfolio unitholders pro-rata.
Disclosures
The circular required that AMCs:
- Disclose the creation of a segregated portfolio to investors within one working day.
- Report the segregated portfolio NAV and main portfolio NAV separately in all daily NAV disclosures.
- Provide specific disclosures in the scheme information document about the side-pocketing mechanism.
First application: DHFL 2019
Side-pocketing was operationalised for the first time at significant scale in May–June 2019 when DHFL defaulted on NCD obligations and multiple AMCs activated segregated portfolios for their DHFL exposures. The DHFL side-pocket was the proof of concept for the mechanism in the Indian market: it isolated approximately Rs 6,000–7,000 crore of DHFL paper across the industry, allowing ongoing scheme redemptions to proceed at main portfolio NAV while DHFL creditors’ recovery claims were worked through the IBC process over 2019–2022.
The DHFL experience demonstrated both the strengths and limitations of the framework. The strength was that it eliminated the first-mover redemption advantage and allowed orderly scheme operation during a prolonged issuer resolution process. The limitation was that investors in segregated portfolio units faced years of illiquidity before receiving partial recovery distributions, and the uncertain timing of those distributions created planning difficulties for investors who had expected the mutual fund to be fully liquid at all times.
Impact and subsequent regulatory refinements
SEBI made minor amendments to the side-pocketing framework in subsequent years, primarily addressing:
- Clarification of the trustee approval process and timeline.
- Requirements for AMC boards to periodically review the status of segregated portfolios and provide investor updates on recovery expectations.
- Guidance on the treatment of segregated portfolio units in investor portfolio statements and consolidated account statements (CAS) issued by CAMS and KFintech.
The Franklin Templeton winding-up of April 2020 also highlighted a boundary case: Franklin Templeton attempted to create side-pockets for Vodafone Idea instruments in March 2020, and SEBI found procedural irregularities in that specific segregation, while generally affirming the framework’s validity.
International context
Side-pocketing is a standard feature of hedge fund structures globally and is used in many jurisdictions’ open-end UCITS-equivalent fund frameworks for credit-impaired assets. India’s adoption was somewhat later than equivalent European frameworks, partly because the relatively low frequency of Indian corporate defaults before 2018 had not provided sufficient empirical pressure for the reform. The IL&FS default provided that pressure decisively.
Key dates
| Date | Event |
|---|---|
| August 2015 | JP Morgan Amtek Auto incident: first redemption restriction in Indian MF history |
| September 2018 | IL&FS default triggers NAV write-downs; industry calls for side-pocketing intensify |
| 28 December 2018 | SEBI circular introducing segregated portfolio mechanism |
| May–June 2019 | DHFL default: first large-scale activation of side-pocketing |
| March 2020 | Franklin Templeton uses (and SEBI later scrutinises) Vodafone Idea side-pocket |