Many potential hedge fund investors have concerns over limitations on their ability to withdraw monies from the fund. It is not uncommon for funds to lock up investor capital for one year after investment and even very long lock in periods of over 7 years, while uncommon, are not unheard of.
Even after the lock up period is over, or apart from the use of lock-ups funds will often restrict investor redemptions to no more frequently than quarterly, semi-annually or even annually. In addition, commonly the investor must give advance notice to the fund manager (e.g. 30 days to 90 days) of his intention to be redeemed. In effect, this is really another form of lock-up.
So, these lock-ups are an evil, correct? Not necessarily.
There are studies concluding that funds with lock-up periods produce higher returns to investors than funds with no lock-up periods.
For example, one study of hedge funds concluded that the excess returns of funds with lock-up restrictions were 4%-7% per year higher than those of non-lockup funds. "Share restrictions and asset pricing: evidence from the hedge fund industry", by George W. Aragon,W.P Carey School of Business, Arizona State University (2004) http://wpcarey.asu.edu/pubs/index.cfm?fct=details&article_cobid=2191560&author_cobid=2181843&journal_cobid=2132752. In this case, the funds studied had lockups from 0 to 90 months with the lock-up funds clustering around 12 months in duration.
Another, more recent, article which first appeared in the Spring 2007 Alternative Investment Management Association Journal by Rajeev Baddepudi of Eurekahedge entitled "Investing in Hedge Funds: A Long Term Proposition?" http://www.aima.org/uploads/EurekaBaddepudi74.pdf also found a positive correlation between lock-ups and higher returns as shown in the chart (click on the chart to enlarge.) In this case, the comparison was between funds with relatively short term lock-ups ranging from none to 1 week to up to 3 months (quarterly).
The two studies might illustrate different aspects of the same point. Aragon says that his studies suggest that an extra 30 day notice period is more important for investors who are not already in funds having a 1 year lock-up. In this regard, one of his models shows that the investment impact of an extra 30 days notice is + 5.20% (annually it seems) for funds with no other lock-up period and + 3.08% for funds that already impose a one-year lock-up period.
One of the reasons posited for the higher returns for lock-up situations is that non-discretionary trading to meet more frequent redemptions is costly. This is avoided where fund flow restrictions are imposed by lock-ups and other restrictions on withdrawal.
Another reason is that fund managers of funds with lock-ups and other restrictions on redemption gravitate toward and are freer to invest in less liquid underlying assets. This, in turn, yields an illiquidity premium return.
Interestingly enough use of lock-ups correlates negatively to off-shore funds. It has been conjectured that the reason for this is that offshore funds tend to attract long-term investors. Much of the return of these funds comes from long-term compounding of tax savings. These funds are typically located in tax havens or locations with low tax rates, so as to not to be subjected to US income taxes. Hence, these funds are not likely to attact short-term investors - so there is little need to use lock-ups to filter them out.
The type of strategy employed by the investment manager is of course a factor in whether or not lock ups will be employed. Funds that invest in highly liquid instruments such as equities, bonds, commodities or certain derivatives thereof tend to have no-lock up or very short lock-ups (e.g. redemption on one week's notice). However, private equity funds with long term strategies, or event driven and distressed managers involved in relatively long term special situations will tend to have longer lock-up periods.
It would be interesting to see more recent studies to help to determine if the positive correlation between investor returns and lock ups has held through the recent liquidity crisis in the markets.
