Chidem Kurdas
Many investors want to have reasonably expeditious access to their money. But high-return hedge fund strategies can require the passage of time. Such strategies are not successful if investors pull out early, forcing the manager to liquidate positions under adverse circumstances.
A one- or two-year lockup agreement provides time. But then the investors face the risk that they will not be able to redeem when they need to.
This dilemma is often resolved with a soft-lockup that allows withdrawal early in the investment, but at a cost. For a fee agreed upon in advance, you can redeem during the specified period.
This cost is increasingly catching investors’ attention. The fees differ widely across funds and strategies. An early withdrawal during a one-year lockup can cost you as little as 1% of the assets, as much as 5% and higher, or any percentage in between.
That’s a new element in the concern over fund expenses. Early redemption is not baked in the way management fees are, but if it does happen the expense is another bite taken from the capital.
Some funds have two-year soft lockups where the withdrawal fee is hefty in the first year but goes down in the second year. Others have a one-year hard lockup followed by a year’s soft lockup.
What determines whether the fee is 1% or 5%? In principle, the more illiquid the strategy, the greater the cost of early withdrawal to the fund and potentially to its clients. So it makes sense for a highly illiquid strategy – for instance one that involves large positions or hard-to-trade instruments – to impose a substantial penalty for early redemption.
If the manager can make the case that the fee properly reflects the liquidity of the strategy, then a high rate becomes acceptable, says an investor. “The purpose of the fee is not to make managers’ life easier but to create the right conditions for the investment strategy,” says this person.
