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  1. 1. Asset Management Lockups by Barry J. Cohen, Senior Managing Director, Director of Alternative Investments, Hedge Funds Bear Stearns Asset Management September 2005 Lockup periods—the minimum amount of time an investor must keep its investment in a hedge fund— continue to gradually increase. In this piece, we explore the cause and implications. What are lockups? There are two types of lockups: hard and soft. A hard lockup is one that prevents an investor from redeeming its investment for a certain period of time. A soft lockup is one which permits redemption only upon payment of a fee. The fee is normally calculated as a percentage of the redemption amount and typically ranges from one to five percent. Redemption fees are usually paid to the fund, and may serve to compensate continuing investors. History of lockups; side letters For many years, a one-year lockup was a standard term for many hedge funds. Liquidity typically was available only as of December 31 of each year, in effect locking investors into a fund for 12 to 21 months. Also, subscriptions were more commonly quarterly than monthly. An exception to this has always been commodity trading advisors (CTAs), which mainly trade futures. CTAs have typically had minimal or no lockups. On occasion, hedge funds would agree, via side letters, to waive lockups partially or totally. More recently, however, side letters that alter substantive terms have been increasingly frowned upon, and investors in a fund are unable to gain exceptions to its lockup terms. For a variety of reasons, hedge fund lockups have been lengthening. Factors contributing to extended lockup periods Recent SEC rules exempt from registration managers whose funds lockup investors for 2 or more years. Managers who were not previously regulated have in some cases extended their lockup period in order to avoid regulation. Another common reason managers lengthen lockups is “because they can”. Hedge funds with more prospective investors than they can accommodate can impose tougher terms on investors without diminishing assets. In some cases, the manager’s style of investing merits a longer lockup. If the portfolio contains less liquid assets, or has a long investment horizon, a longer lockup prevents redemptions from forcing sale of assets at inopportune times. If the portfolio assets are illiquid, early redemption could lead to selling at a discount to value. Such sales harm the return of the entire portfolio and thus negatively impact remaining 1
  2. 2. Asset Management investors and redeeming investors alike. (Sometimes, this type of harm can be mitigated by charging redeeming investors a redemption fee.) Portfolios that might justify longer lockups include, by way of example, those containing direct lending and private equity type investments. In evaluating the reasons for a long lockup period, one question investors should ask is, “Does the manager have too many investment opportunities or too few?” Which brings us to the next topic: Is a long lockup cause for enhanced due diligence? A long lockup can raise a red flag As discussed previously, a manager’s investment style may indeed merit a longer lockup. Another possibility, however, is that the manager is running low on investment ideas or is otherwise anticipating weaker performance. While fund performance is still relatively strong, the manager may decide to take the opportunity to lengthen lockups to prevent performance-related redemptions. Even if the lockup is justified by the portfolio’s diminished liquidity, this raises many due diligence issues. Illiquid investments (aside from being hard to dispose of) are often difficult to price. If the investment trades infrequently, how will it be valued when reporting the fund’s net asset value to investors? If the portfolio’s liquidity has recently changed, investors should ask whether its assets continue to be of a type that the manager has expertise managing. For example, a long/short equity manager may have considerable talent for investing in liquid stocks. If the manager increases its lockup period to accommodate a foray into private equity, this should trigger an inquiry into the manager’s talent for making this new type of investment. The investor might also want to investigate whether there are other managers (like private equity managers) who could do a better job in this new asset class. Also, the investor may feel it already has exposure to the new asset class elsewhere in its portfolio. Enhanced due diligence If an investor is forced to remain invested with a manager for a longer period of time, the investor should subject the manager to a higher standard. Private equity managers, for instance, typically hold onto investors’ money for 7-10 years. Consequently, investors routinely conduct intense investigations on the likelihood that a fund’s management team will remain intact for the duration of the fund. Investors might request a list of every employee who has left the manager’s employ in the last 7 years. Contrast this with a CTA who offers investors weekly liquidity. If 2 years into the investment the management team’s turnover seems too high, an investor can liquidate almost immediately. The more a hedge fund starts looking like a private equity fund, the more private-equity-type due diligence is merited. Collateral effects of longer lockups; market impact on convertibles? Some funds not only lock up investors for extended periods of time, but may also limit redemptions to a particular day of the year, like December 31 or the anniversary date of an investor’s investment. To the extent that a number of funds in a particular investment style share the same annual redemption date, it could impact markets. Convertibles For instance, the convertibles market has recently been depressed, in part due to selling by convertibles funds. They have been selling in part due to investor redemptions. Many 2
  3. 3. Asset Management convertibles funds, however, have an annual, December 31 redemption date, with 60- to 90-day notice periods. So if investors in these funds elected to redeem on December 31, 2004, they would have had to give notice in October or November 2004. Last fall, convertibles were not faring well, but the asset class had not yet fallen out of favor with hedge fund investors the way it ultimately did in the spring of 2005. Accordingly, investors in December 31 lockup funds had no opportunity to redeem this spring when the market turned down sharply. Their first opportunity to redeem will be December 31, 2005. Many hedge fund investors wonder whether there will be “another leg down” in the convertibles market when these investors can finally get out. (The other side of the issue is that the potential upcoming wave of redemptions has already been anticipated by the markets.) Another collateral effect of long lockups occurs when a fund that has been closed for a while opens up to new investors. Lockups of previous investors may have expired, allowing them to withdraw at any time, whereas the new investors are locked in. Ironically, the fund’s long lock up could permit disruptive withdrawals that potentially place new investors at a disadvantage. Side pockets A side pocket is a special form of lockup. A side pocket is essentially a lockup that applies to only a portion of a hedge fund’s portfolio—usually one or more private-equity-type investments. Side pockets essentially split the hedge fund portfolio into liquid and illiquid portions. The investor’s interest in the side pocket is not redeemed when the investor redeems the liquid portion of the portfolio. Rather, the side pocket investment is typically paid out to the investor only when the fund sells the investment—even if the sale occurs long after the redemption of the liquid portion of the portfolio. Side pockets raise extensive due diligence issues, including: How is the value of the side pocket determined prior to liquidation? How does the calculation of management and incentive fees account for the value of the side pocket? Is the percentage of the portfolio that can be comprised by side pockets appropriately limited? Exceptions to lockup provisions Lockup provisions may be suspended in the event of the departure of a portfolio manager or upon the withdrawal of a significant portion of his or her capital. Gates and force majeur terms Two other types of hedge fund terms that can affect liquidity are “gates” and “force majeur” terms. A gate allows the manager to prohibit redemptions of more than a certain percentage of the fund’s assets on any particular redemption date. Investors may wish to inquire the circumstances under which the gate will be employed. Investors should take note of whether redemption requests that are limited by a gate provision are automatically resubmitted for the next redemption date or whether the investor must proactively resubmit it. Force majeur terms simply give the manager the right to prohibit all redemptions in the event of extraordinary circumstances. 3
  4. 4. Asset Management Differing perspectives for different types of hedge fund investors Some long-term investors, like pension funds, may be less concerned about lockups. They have long time horizons that can span decades. Their investments are purchased with the intent of keeping them for many years. Funds of funds (which currently supply a large percentage of all hedge fund assets under management), on the other hand, may have much shorter time horizons. Funds of funds themselves often offer their investors the right to redeem after only a year. They can ill afford too many investments with managers requiring two-year lockups. If a large number of a fund of funds’ investors redeem at a time when the fund of funds cannot itself redeem locked up investments, obvious problems result. Note, however, that even a long-term investor benefits from a short lockup because it enables the investor to bail out early in the event it makes a mistake or otherwise changes its mind. The lockup paradox Longer lockups can paradoxically lead a hedge fund to have fewer assets under management. This can result simply because a long lockup may render a fund less popular. Or, in the case of annual redemption funds, this can result more indirectly due to investors redeeming rather than “re-upping” for another full year. If an investor in such a fund thinks it even might need to reduce its hedge fund portfolio in the coming year, or has concerns about the style category of the fund, it may be reluctant to invest if it cannot redeem its investment more quickly. Long lockups are not necessarily bad for investors It is not the case that hedge fund investors unilaterally want short lockups, and hedge fund managers want long lock ups. The goal for each should be appropriate lockups. If a fund’s portfolio contains a large number of private equity investments, yet offers investors quarterly liquidity on 30 days’ notice with no lockup, is this a rare, good opportunity for investors? Probably not. If too many of the fund’s investors redeem, the fund may be forced to sell illiquid investments at depressed prices, thereby harming both redeeming and remaining investors. (If you ever do see an opportunity like this, there is probably a gate or right of the manager to prohibit redemptions in its discretion.) Conclusion Lockups should be an important factor that hedge fund investors consider as part of the due diligence process. This is particularly true in today’s environment, since hedge fund lockups have continued to lengthen and investors are increasingly unable to gain exceptions to lockup terms. Investors should carefully assess the many implications longer lockup periods entail, some of which may be beneficial while others may be disadvantageous. In the end, the investor’s goal should be to invest in quality funds with appropriate lockups based on its individual time horizon and liquidity needs. Please be aware that this commentary is a product of Bear Stearns Asset Management Inc., and should not be viewed as a solicitation for the purchase or sale of a security. For more information call Heather Malloy, Ken Mak or your Bear Stearns Asset Management salesperson. Bear Stearns Asset Management Inc. 383 Madison Avenue, New York, NY 10179 (800) 436-4148. 4