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A Simple Model for the Expected Premium for Hedge Fund Lockups

What excess return should a fund of funds expect to earn for investing in a hedge fund with an extended lockup?

In this paper we present a simple model for estimating the premium for long-term lock-ups. Because there is a demonstrated statistical persistence to the quality of hedge fund returns within a particular hedge fund strategy – above average funds tend to continue to do well, and below average funds continue to falter – a lockup deprives an investor of the opportunity to redeem an investment in poorly performing funds and reinvest the pro-ceeds in successful ones. The value of that lost future opportunity is the expected pre-mium for committing to the lockup.

We estimate the value of the premium for multi-year lockups in a variety of strategies using a discrete-time Markov chain model for the evolution of hedge funds, in which a hedge fund at any time can be in one of three states: Good, Sick or Dead. For convertible bond funds, for example, the return premium for a two-year lockup over a one-year lockup is approximately 48 b.p. per year. The premium rises to 76 b.p. per year for a three-year lockup, and approaches a limit of 156 b.p. as the duration of the lockup be-comes infinite. The premium increases monotonically with to the degree of persistence of returns within a strategy and is proportional to the standard deviation of the returns them-selves, so that strategies with greater standard deviations and/or greater persistence re-quire greater compensating lockup premiums.…

Published in Finance