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A lock-up period is the minimum investment holding period required by hedge funds. During the lock-up period, the investors cannot take money out of the fund. The hedge fund industry distinguishes between hard and soft lock-ups. A soft lock-up can be neutralized by paying an early redemption fee, a hard lock-up cannot. In general, most hedge funds require a 12-monthlock-up period.
A lock-up period also refers to the initial subscription—hence, when reinvesting more funds, investors are again subject to the lock-up period, even if the initial period has expired. Lock-ups mean more flexibility for hedge fund managers because they can stay invested in illiquid assets for a longer period of time.
Numerous academic studies have found a positive correlation between the length of the time the capital is invested and the hedge fund performance. One explanation for this phenomenon may be the illiquidity premium investors realize if they are willing to provide capital to a hedge fund over the long term.
The liquidity realized by hedge fund investors, however, is always expected to be a function of the liquidity of the traded instruments. Aragon (2004) found that the yearly return of hedge funds with lock-up periods is about 4% higher than the return of those without lock-up periods.
Agarwal et al. (2004) found that hedge funds with a respective track record and a lock-up period generally do not receive the same amount of capital as comparable hedge funds without lock-up periods.
At the same time, however, they note that hedge funds with restrictive capital outlow mechanisms are expected to show better future returns because of the possibility of holding illiquid positions. These results coincide with those of Liang (1999), who finds that the large hedge funds with long lock-up periods and short track records exhibit superior performance overall.