Working Paper: NBER ID: w15937
Authors: Andrew Ang; Nicolas PB Bollen
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 three. The cost of illiquidity can easily exceed 10% if the hedge fund manager can arbitrarily suspend withdrawals.
Keywords: Hedge Funds; Liquidity; Real Options; Lockups; Notice Periods
JEL Codes: G11; G23; G24; G32; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| cost of redemption restrictions (lockups and notice periods) (G33) | investor's valuation of hedge funds (G23) |
| risk aversion (D81) | cost of redemption restrictions (G33) |
| poor performance (D29) | likelihood of fund failure (G33) |
| likelihood of fund failure (G33) | perceived costs of illiquidity (G33) |
| fund performance history (G14) | investor's valuation of liquidity option (G19) |