49 Pages Posted: 30 Oct 2008 Last revised: 17 Nov 2012
Date Written: October 21, 2008
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 investors 1.5% of their initial investment. The magnitude is sensitive to a fund's age, expected return, and the liquidation cost upon failure. The cost of illiquidity can exceed 10% if the hedge fund manager suspends withdrawals.
Keywords: Cost of illiquidity, hedge fund valuation, exercise restriction, redemption notice period, lockup, suspension clause
JEL Classification: G13, G23, C63
Suggested Citation: Suggested Citation
Ang, Andrew and Bollen, Nicolas P. B., Locked Up by a Lockup: Valuing Liquidity as a Real Option (October 21, 2008). Available at SSRN: https://ssrn.com/abstract=1291842 or http://dx.doi.org/10.2139/ssrn.1291842