From the February 2007 issue of Investment Advisor • Subscribe!

Lock-Ups Should Pay Up

There is an increasing number of hedge funds asking for lock-ups, and lock-up periods are getting increasingly longer, but what excess return should you ask in return for allowing your money to be locked up?

One of the main effects of a lock-up is that it deprives investors of the option of redeeming one fund to invest in another. So the excess return investors should expect equates to the opportunity cost that is lost by renouncing this periodic option.

Evidence suggests that there is a degree of predictability and persistence in the performance of hedge fund managers. "The hypothesis is basically that hedge fund alpha takes skill, and skill persists," explains Emanuel Derman, director of Columbia University's financial engineering program and head of risk at Prisma Capital Partners, a fund of hedge funds launched by former Goldman Sachs executives at the start of 2005.

The statistics he offered seemed to support the hypothesis. Classifying hedge fund managers as "good" (those who match or outperform peers using the same strategy), "sick" (those who regularly underperform the strategic benchmark) and "dead" (the 3% to 5% of funds that close each year due to consistently substandard performance) he noted that a fund that was "good" one year had an 85% probability of being "good" the next year. Similarly, a fund that was "sick" one year had a 65% probability of remaining sick the next, and just a 35% probability of getting better. The probability of a sick fund ending up among the dead was negligible, he said, but this already begs the question, "Where do the 3% to 5% of dead funds come from?"

If we put our faith in these statistics--and even if we do not--it is reasonably logical that investors in a "good" fund will tend to stay there, lock-up or no. Investors in a "dead" fund will get the residue of their money back once the fund has been liquidated and redeploy it. Here, too, the presence or absence of a lock-up makes no difference.

So there is no optionality in either of the first two cases.

The only optionality, then, lies in the case of a "sick" fund where, if an investor can redeploy to a better performing fund, he will do so, unless prevented from doing so by the terms of a lock-up. In this case, the effect of the lock-up "is to deprive the fund of funds manager [or any other investor] of this periodic option to redeem from one fund and invest in another," said Derman.

Crunching the numbers concerning sick funds (bearing in mind that there is no "optionality" in the case of either "good" funds or "dead" ones) and the probabilities that they will remain sick, get better, or die and factoring in the likelihood of performance regressing toward the mean, Derman has come up with a result: An investor agreeing to a three-year lock-up should expect returns of 130 basis points per year over and above what would be expected if there were no lock-up.

So, what does this mean for investors? One logical conclusion would be for investors to require compensation for the opportunity costs of agreeing to a lock-up. For example, investors in funds wishing to apply a three-year lock-up might expect the fund's high water mark to be raised by 130 basis points with respect to funds using the same strategy but with no lock-up.

Good luck getting that side letter.

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