What is a hedge fund lock-up?
Recently there have been many discussions about hedge fund structures and terms, including the ability (or inability) of investors to withdraw from hedge funds. Generally the manager will have a number of structures in place to make sure that capital stays in the hedge fund. These provisons include the hedge fund gate, the ability to limit all withdrawals in certain circumstances, and the hedge fund lock-up provision.
The hedge fund lock-up provision is a provision which provides that during a certain initial period, an investor may not make a withdrawal from the fund. The period when the investor cannot withdraw the funds is known as the actual lock-up period.
What are common lock-up periods for funds?
This is a common question for many start-up hedge funds. Generally it will depend on the hedge fund investment strategy which is utilized. As a general rule of thumb the lock-up should be as long as necessary for the investment manager to implement his strategy. For example, if a manager expects that it will take a year or more to see any results from the investment strategy, then the lock-up should be at least a year. If the investment strategy is more short term in nature, like day trading, then the lock-up period should probably be shorter.
However, the length of the lock-up is really a business decision that the manager will have to make and the manager should consider how potential investors may react to an overly long lock-up period. Managers should also be flexible with the lock-up in certain circumstances. Some investors negotiate with the hedge fund manager for a reduced lock-up period, or no lock-up period. Such agreements are solidified through the use of a side letter between the hedge fund manager and the investor.
Additionally, fund-of-hedge funds will need to know the lock-up periods of the hedge funds in which they invest so that the lock-up period at the fund-of-funds level is appropriate for such fund’s cash management purposes.
What about two -year or longer lock-up periods?
The two-year lock-up period used to be popular. This was a direct reaction to the now defunct hedge fund registration rule. The rule required hedge fund managers to register with the SEC as investment advisors unless the hedge fund instituted a two-year lock-up period. In response, many managers changed their lock-up period to two years. After the hedge fund registration rule was vacated by the courts, (see Goldstein – End of the Hedge Fund Registration Rule) the two-year lock-up period became less popular.
Lock-up periods longer than two years are more rare. There are private equity funds which have long lock-up periods, but generally these groups have long and successful track records and design products for the very large institutional investors. Generally, most high net worth investors want to have some access to their capital, which we have seen with the recent market downturn.
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