Soft Lock-Ups Help Hedge Fund Managers Reconcile the Goals of Stable Capital and Investor Liquidity

What do hedge fund liquidity management tools (lock-ups, gates, suspensions and the like) and garbage dumps have in common?  Both categories are characterized by a “not in my backyard” mentality.  In the dump context, people want the benefit of a faraway dump (the ability to use and dispose of goods), but do not want the burden of a nearby dump (pollution, nuisance, olfactory offense).  Similarly, in the hedge fund liquidity management context, investors want the benefit of judiciously-deployed liquidity management tools (the greater returns that often come from a less liquid portfolio), but do not want the burden of investor-level illiquidity (an inability to get your money back when you want it).  Indeed, a large part of the tension between hedge fund managers and investors during the credit crisis arose out of precisely this “liquidity management NIMBYism.”  By and large, investors did not object to declining performance, per se.  Rather, they objected to the inability to get their money back, roughly on demand; and investors objected more strongly where they, in turn, had their own investors demanding to redeem.  Managers and investors sought to structure around the potential liquidity problems of commingled hedge funds by turning with increasing frequency, in the wake of the crisis, to managed accounts and single investor hedge funds.  See “Single Investor Hedge Funds Offer the Benefits of Managed Accounts and Additional Tax and Other Advantages for Hedge Fund Managers and Investors,” Hedge Fund Law Report, Vol. 3, No. 16 (Apr. 23, 2010); “How Can Hedge Fund Managers Structure Managed Accounts to Remain Outside the Purview of the Amended Custody Rule’s Surprise Examination Requirement?,” Hedge Fund Law Report, Vol. 3, No. 5 (Feb. 4, 2010).  However, by most accounts, the use of managed accounts and single investor hedge funds has not been as prevalent as anticipated in late 2009.  Rather, hedge fund managers have been finding creative ways to accommodate the liquidity needs of investors in the classic commingled hedge fund structure.  One such method is the so-called “soft” lock-up.  In a typical hedge fund investment, the investor cannot get its capital back or “redeem” – that is, the investor’s capital is “locked up” – for a period following the date of investment.  That period is specified in the governing documents of the fund, and generally is one to three years.  (Following expiration of the initial lock-up, the investor generally may redeem its initial capital commitment – plus or minus any gains or losses and net of applicable fees and holdbacks – periodically, e.g., monthly, quarterly, semiannually, annually or biennially.  Generally, investors must provide written notice of intent to redeem 30 to 90 days prior to a scheduled redemption date.)  Traditionally, that initial one- to three-year period during which capital could not be redeemed was known simply as the “lock-up” period.  Now, with the advent of “soft” lock-ups, that traditional approach is known as a “hard” lock-up period.  A soft lock-up works much like a hard lock-up, but with one key difference: an investor can redeem during the soft lock-up period by paying a redemption penalty to the fund.  This article discusses: the mechanics of and rationale for traditional or “hard” lock-ups; the interaction between the liquidity of a hedge fund’s strategy and the length of a lock-up; the practical and fiduciary duty considerations in connection with granting waivers from hard lock-ups; the interplay between secondary market transactions and lock-ups; holdbacks; three methods for calculating soft lock-up redemption penalties, including accounting and tax considerations; the three chief rationales for soft lock-ups; variations on the lock-up structure; and empirical data on institutional investor tolerance for soft lock-ups versus hard lock-ups, and lock-ups generally, and the marketing implications of this data.

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