Hedge fund terms: lock-ups, redemptions and valuation

Read the exit before the entry

A hedge fund is private and unregistered, so it is not bound by the rule that mutual fund shares be redeemable at net asset value every day. Its own terms decide how investors get out. Many funds start with a lock-up period, often a year or more, during which an investor cannot cash in. After that, redemptions typically come only on a few set dates a year.

Other terms add friction. A fund may charge a redemption fee when shares are cashed in. A fund may also reserve the power to suspend redemptions, for example in market distress or when its holdings cannot be sold quickly. Money that may be needed by a fixed date does not belong in a fund whose exits can close.

Valuation is the other question. Hedge funds may hold investments that are hard to sell and hard to value, such as private loans or thinly traded bonds. The reported value then rests on the fund’s own method, so an investor should ask how holdings are valued and how much is valued by independent sources.

Two documents do the explaining. The offering memorandum and related materials set out the strategy, risks and terms; a private fund has no statutory prospectus. If the manager is an SEC-registered investment adviser, its Form ADV, found through Investor.gov, shows its background and any disciplinary history.

Three more questions protect the investor. Does the fund use leverage? Borrowing magnifies both gains and losses and can make a conservative portfolio extremely risky. How is performance calculated? Hedge funds follow no standard method, so ask whether figures reflect cash actually received or the manager’s estimates, and whether fees are deducted. Who holds the assets? The manager can usually move them, so ask where they are held and whether an outside auditor verifies them; the prime broker, administrator and auditor can be contacted to check what the manager says.

Exam terms

Lock-up period

A period after investing during which the investor cannot cash in.

Redemption date

One of the set dates on which a hedge fund lets investors cash in.

Redemption fee

A charge taken when shares are cashed in.

Suspension of redemptions

A fund’s use of its power to stop cashing in, for example in market distress.

Offering memorandum

A private fund’s offering document: strategy, risks and terms.

Form ADV

An investment adviser’s registration form, showing background and discipline.

Worked example

Imelda Garrowby invests in a hedge fund with a one-year lock-up, quarterly redemption dates and a redemption fee.

1. For the first year she cannot cash in, whatever happens to her plans.
2. After the lock-up she can ask to redeem, but only for the next set date, and the fee comes out of what she receives.
3. If markets seize up and the fund’s holdings cannot be sold quickly, the fund may suspend redemptions under its terms.
4. Before investing she read the offering memorandum, asked how the fund values its private loans, and checked the manager’s Form ADV.

Check yourself

Try a question, then read the explanation to review the rule.

Same rule, new context

Related practice

• Hedge fund structure and investor featuresPractice this
• Private fund disclosure, valuation and adviser dutiesPractice this
• Hedge fund due diligence: leverage, performance figures and safekeepingPractice this