What is side pocketing?

In the second meeting of MFAC (Mutual Fund Advisory Committee) this month discussions happened on rules governing debt mutual funds. Yet the market regulator, Securities and Exchange Board of India (SEBI) has not come forward with respect to side-pocketing, but definitely, there is a possibility of SEBI introducing side-pocketing in mutual funds.
 
Side-pocketing is widely used by the hedge funds and is nothing but the method wherein illiquid investments are separated from those which are more liquid. If SEBI introduces the side-pocketing for mutual funds, then the fund houses would be allowed to keep apart risky assets from the remaining holdings and cap its redemptions. In a nutshell, fund houses would be able to create two funds one with risky assets and another with the remaining assets retaining its features. So when there is a downgrade in ratings, the illiquid assets would be moved to the side-pocket and allocation would be done to the existing unitholders on a pro rata basis.
 
In the case of side-pocketing, there would be two NAVs, one with the remaining liquid assets and the other with the risky illiquid assets estimated based on the realisable for the investor. So you may be wondering why at all it is required to do this. This is because side-pocket would ensure that if there is any future recovery from the assets then only investors who were in at the time when the illiquid assets were to move to side pocket receive its benefits.