Funding Liquidity Risk and the Dynamics of Hedge Fund Lockups

Abstract

We exploit the expiring nature of hedge fund lockups to create a new measure of funding liquidity risk that varies within funds. We find that hedge funds with lower funding risk generate higher returns and this effect is driven by their increased exposure to equity mispricing anomalies. Our results are robust to a variety of sampling criteria, variable definitions, and control variables. Further, we address endogeneity concerns in a variety of ways, including a placebo approach and regression discontinuity design. Collectively, our results support a causal link between funding risk and the ability of managers to engage in risky arbitrage.

Keywords: Hedge Funds, Funding Liquidity Risk, Lockup

JEL Classification: G10, G23