Locked Up by a Lockup: Valuing Liquidity as a Real Option

Abstract

Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with CRRA utility and risk aversion of 3. The magnitude is sensitive to a fund's age, expected return, volatility, and the liquidation cost upon failure. The cost of illiquidity can easily exceed 10% if the hedge fund manager suspends withdrawals.

Keywords: hedge fund lockup, withdrawal, redemption notice period, suspension clause

JEL Classification: G23, G13