Lock up periods are windows of time when investors in a hedge fund or another closely held investment vehicle are not allowed to redeem or sell shares. The lock up period helps portfolio managers avoid liquidity problems while capital is put to work in sometimes illiquid investments.
The initial public offering (IPO) lock up is a typical lock up period in the equities market used for newly issued public shares. It typically lasts anywhere from 90 to 180 days after the first day of trading so that fund managers can keep a lower amount of cash on hand.
The lock up period for hedge funds corresponds with the underlying investments of each fund. For example, a long/short fund invested mostly in liquid stocks may have a three-month lock up period. Because event-driven or distressed hedge funds often invest in more thinly traded securities like loans or other debt, they tend to have prolonged lock up periods. Still, other hedge funds may have no lock up period at all depending on the structure of the fund’s investments.
When the lock up period ends, investors may redeem their shares according to a set schedule, often quarterly. They normally must give a 30- to 90-day notice so that the fund manager may liquidate underlying securities which allow for payment of the investors.
Lockups are designed to prevent insiders from liquidating assets too quickly after a company goes public. When employees and pre-IPO investors initially get their shares or options, they sign a contract with the company that typically prohibits trades for the first 90–180 days after a future IPO. When the company is ready to go public, the underwriting bank then reaffirms the existing agreements in new contracts. This helps to ensure the market will not disproportionately increase the supply, which drives prices downward. While lockups used to be simple—usually lasting 180 days for everyone—they have become increasingly complex.
Importance of a Lock Up Period for a Hedge Fund
During the lock up period, a hedge fund manager may invest in securities according to the fund’s goals without concern for share redemption. The manager has time for building strong positions in various assets and maximizing potential gains while keeping less cash on hand. In the absence of a lock up period and scheduled redemption schedule, a hedge fund manager would need a great amount of cash or cash equivalents available at all times. Less money would be invested, and returns may be lower. Also, because each investor’s lock up period varies by his personal investment date, massive liquidation cannot take place for any given fund at one time.
Lock Up Period for an IPO
The lock up period for newly issued public shares of a company helps stabilize the stock price after it enters the market. When the stock’s price and demand are up, the company brings in more money. If business insiders sold their shares to the public, it would appear the business is not worth investing in, and stock prices and demand would go down.
When a private company begins the process to go public, key employees are paid little in exchange shares of company stock. Because receiving stock is the equivalent of receiving a paycheck, many of these employees want to cash in their shares as quickly as possible after the company becomes publicly traded. The lock up period prevents stock from being sold immediately after the IPO when share prices may be exaggerated and likely to drop after the company’s IPO.
Example of a Lock Up Period
In March 2015, Alibaba Group Holding Inc.’s six-month lock up period ended. Company insiders owning 437 million shares, approximately 18% of the outstanding shares, were allowed to sell their stock. Many investors were more concerned with receiving profits than with their cost basis. As a result, the stock price decreased dramatically.
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