Locked Up by a Lockup: Valuing Liquidity as a Real Option
Financial Management 39, p.1069-1095, 2010

Nicolas P.B. Bollen and Andrew Ang

ABSTRACT
Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investorís 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 3. The magnitude is sensitive to a fundís age, expected return, volatility, and the liquidation cost upon failure. The cost of illiquidity can easily exceed 10% if the hedge fund manager suspends withdrawals.