Limited Partners

Kissing a dolphin
Kissing a dolphin

Limited partners are investors in a limited partnership. A limited partnership is a professional intermediary specialized in fund management that raises capital from investors, or the limited partners, and invests the money in corporations in exchange for ownership stakes.

The limited partners provide the capital but do not take part in managing the fund or advising the portfolio companies, which is a major responsibility of their counterparts (the general partners).

Like the shareholders in a corporation, limited partners also have limited liability, that is, liable only to the extent of their original investment, and are protected in general from any further losses and legal actions.

The general partners manage the funds and assume the financial and legal obligations. The limited partners have priority over the general partners upon liquidation and receive a large fraction of the capital gains proportional to their original investments as defined by the partnership agreement.

They can be wealthy individuals or corporations and can choose to invest in limited partnerships instead of directly in the companies because they do not have the expertise in the field nor access to information in the private equity market that the general partners have. They pay the general partners a fee to cover the costs of fund management.

Limited Partnership and LLC

Limited Partnership and LLC - ✯ Western Antarctica Peninsula
Limited Partnership and LLC

A limited liability company (LLC) and a limited partnership (LP) are two types of corporations in the United States. LLCs offer limited personal liability to their owners while its other characteristics make it more like a partnership.

The LLC provides greater management flexibility and allows pass through taxation (i.e., no double taxation) for investors. Another important advantage of LLCs compared to other corporations is that there are fewer administrative requirements; for example, it is not necessary to hold an annual shareholders’ meeting.

With small LLCs the owners participate equally in the management of their business, which is called member management. An alternative management structure, one that is widespread in the hedge fund industry, is manager management.

In this case the management is delegated to one or more owners (sometimes even to outsiders), which act as agents of the LLC and make the management decisions. The nonmanaging owners do not participate in the day-to-day operations but they do share the LLC’s profits.

A limited partnership is distinct from a limited liability company, with regard to liability and taxation. LPs consist of general partners and limited partners. The general partner is responsible for the management activities and has full liability for the debts of the partnership.

The limited partners are not involved in the operations of the company; they just supply the capital. Furthermore, they are only liable to the extent of their investment. The general partners pay the limited partners a dividend on their investment as compensation. The residual remains for the general partners.

There are comparable corporate entities in other countries. Counterparts of the LLC are the British Limited liability partnership, the German Gesellschaft mit beschränkter Hatung, or the Japanese godo kaisha. However, the characteristics of LLCs and LPs described here are specific to the United States.

Liquid Markets

Liquid Markets - Style Deals - A woven romper featuring a lace-up front, V-neckline, an elasticized waist, and long elasticized sleeves.
Liquid Markets

Originally, liquidity represents the easiness for a security to be converted into cash in a very short term (e.g., stocks, Treasury bonds, and money market securities are liquid assets). Such a concept is closely linked to the reversibility feature of an investment in financial securities.

Generally, liquidity reflects the easiness for market participants (e.g., investors, dealers, brokers) to find a counterpart to trade with. In a liquid market, trading takes place continuously at both the buy side and sell side levels.

Financial markets generally intend to provide investors with liquidity, which requires transaction services as well as corresponding costs, and implies also transaction costs. these types of costs may impact securities’ market prices in the short term.

Namely, the service offered for being able to trade a security at any time has a price (e.g., bid-ask spread). However, liquid markets are usually characterized by low transaction costs and high trading volumes.

In particular, market microstructure defines a liquid market as a market exhibiting tightness (i.e., small bidask spreads), depth (i.e., small price impact of large trades), and finally resilience (i.e., closeness of observed market prices and fair asset values).


Liquidate - Sunset and birds

A trader liquidates a position when an existing position is converted to cash. In the futures market, there are three means to close or liquidate a futures position: delivery, offset or reversing trade, and exchange-for-physicals.

Delivery allows completion through cash settlement where traders execute payment at expiration of the contract to settle any gain or loss. The vast majority of contracts are closed via other means of delivery or cash settlement.

Offset or reversing trades occur when the trader executes a trade in the futures market to balance the net futures position to zero or flat. The majority of futures contracts are closed or liquidated through offset or reversing trades. Exchange-for-physicals (EFP) is a third way to close a position.

In an EFP, two traders agree on the price of the physical commodity and agree to cancel of their futures and then proceed to take or make the delivery of the commodity. A position may also be liquidated by a broker if the customer or trader fails to meet a margin call. Every participant on the exchange is required to recognize the day’s gains and losses on trades.

If the amount of a loss in a customer’s account falls below an initial margin requirement, a margin call is issued by the futures commission merchant. The trader must supply enough funds to meet or exceed the initial margin requirement; if this is not met, then the futures commission merchant may liquidate the positions to cover the margin call.


Lock-Up - Lake Wanaka, New Zealand

A lock-up prevents certain shareholders of a firm from selling their shares during and/ or after the placement of shares in the stock markets. Usually, lock-up requirements are part of the legal conditions for a public offering.

The general rationale behind lock-up provisions is to protect new shareholders for a certain period of time from potential losses caused by old shareholders unwinding their investments by selling large stock packages.

Such negative stock price reactions can economically be viewed as market participants’ interpretations of negative information about the value of the companies revealed by the potentially strategic behavior of the inside investors.

Empirical studies about stock price behavior around lock-up expiration dates have shown that in venture capital finance this problem is even more important for a number of possible reasons. First, because of the predominant role of informational asymmetries about project quality, the capital market learns about the company value only in the subsequent time after the initial public offering (IPO).

Additionally, venture capitalists are generally perceived as active investors, adding value to the companies beyond their capital contribution by means of their management knowhow, reputation, etc. Hence, if the venture capitalists leave too early, it may have negative consequences for the further development of the firm value.

Other possible sources of uncertainty about strategic behavior of investors in venture capital-backed companies with respect to the amount and time of their disinvestments in and after an IPO are, for example, tax considerations or the opportunity costs of nonredeployed cash, relative to alternative investment opportunities.

Investors in venture capital–backed firms, therefore, face the fundamental trade-off between selling their shares early at an underpriced value and waiting until the fundamental value of the firm is revealed.

In order to improve transparency and impose credible limitations to strategic behavior, lock-up clauses are often agreed upon as explicit covenants in financing contracts specifying different lock-up periods between the venture capitalist and other related insiders such as company founders, management, other investors, etc.

Lock-Up Period

Fisherman's Bastion, Hungary, Budapest
Fisherman's Bastion, Hungary, Budapest

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.

Long Position

Black Beach, Iceland
Black Beach, Iceland

In finance, a long position indicates that the investor/trader promises to purchase an asset in the future. As a result, an increase in the asset price creates a gain for the holder of a long position contract.

In the derivatives market, a long position implies that the holder of a long position contract promises to purchase the asset at a prespecified price for the delivery of the asset at a future date. For example, a trader taking a long position in a commodity futures contract promises to purchase the commodity at the delivery date by paying the prespecified future price at the delivery date.

Similarly, a long position in a call option for a foreign currency indicates that the holder of the option contract will take delivery of the foreign currency at the maturity (or perhaps before maturity depending on the type of option contract).

To sum up, one of the parties to a contract involving a derivative assumes a long position and commits to buying the underlying asset/instrument on a certain future delivery date for an agreed-upon price. The other party takes a short position and commits to selling the same asset/instrument on the same delivery date for the same agreed-upon price.

Long Short Equity

Stradbroke island, Brisbane, Australia
Stradbroke island, Brisbane, Australia

“Make money on alpha.” Long short equity ” is a strategy that belongs to the category of opportunistic strategies. In long short strategies, undervalued equities that are expected to rise are bought long and/ or overvalued equities that are expected to decline are sold short on spot and on futures markets. The long short disciplines are equity hedge, equity nonhedge, and short selling.

Equity hedge portfolios are, usually, leveraged long positions that are hedged with derivative securities or short selling of stocks/stock indices at all times. For example, a manager could hedge the market risk with a put option on the relevant index. Equity nonhedge funds are very similar to traditional investment funds.

Typically, they are long in equities and perform stock picking, but occasionally they also make use of derivatives and short selling. Short sellers concentrate on stocks with expected price losses. they generally assume that the market for short sales is less efficient because most investors try to find undervalued stocks.

Among others as a consequence of the chosen long short discipline, the long short equity portfolio can be long biased, short biased, or market neutral. A long biased portfolio has a net long position that results in a positive correlation to the market.

The opposite is true for a short biased portfolio. thus, the hedge funds can actively participate in falling (negative beta) or rising (positive beta) markets (market timing strategy). the special case of zero beta is called market neutral. For instance, this can be reached by the use of index derivatives.

Lookback Straddle

Twizel, Canterbury, New Zealand
Twizel, Canterbury, New Zealand

A lookback straddle is an option strategy composed of a lookback call option and a lookback put option. The former grants its holder the right to buy an asset at the lowest price observed during the lifetime of the option while the latter grants its holder the right to sell the same asset at the highest price observed during the lifetime of the option.

A lookback straddle thus enables the investor to “buy low and sell high.” Goldman et al. (1979) discuss a closed-form solution for its Black–Scholes no-arbitrage price.

Among option strategies, the lookback straddle is of particular interest due to its close connection to the return profile of trend-following hedge funds. More specifically, the majority of commodity trading advisers, or managed futures funds, are “trend followers.”

So-called primitive trading strategies (PTS) capture the essence of such dynamic trading strategies using static easy-to-understand algorithms. For example, the payoff of a perfect market timer who may only take a long position should be identical to the payoff from holding a call option.

If, on the other hand, it is possible to go long or short, the perfect trend follower should “buy low and sell high,” which exactly corresponds to the payoff of a lookback straddle. Consequently, the lookback straddle can be thought of as the PTS used by market timers.

Loss Standard Deviation

Loss Standard Deviation - Touchdown in Tucson
Loss Standard Deviation

When thinking about the concept of risk, investors usually think about losses. Most often people think about risk as the standard deviation or volatility of all returns. In contrast, loss standard deviation measures the variability of returns below the target return. All positive returns are treated as zeros in the calculation as below:

T in the above equation can be thought of as a target rate where outperformance is measured. For example, a pension fund may have a target funding assumption that it must earn to be able to fund its pensioners.

Any return lower than this can be considered a loss (even if the absolute return is positive) because the result falls short of what must be earned by the fund to meet its liabilities. In this case if the funding assumption is a 0.5% monthly return, anything less than 0.5% is taken into consideration in the calculation. Alternative target rates are typically the risk-free rate or zero.

The loss standard deviation was proposed because some investors do not believe that positive returns should be included in measurement of risk and therefore look to only consider negative returns.

As such some investors replace the concept of standard deviation with loss standard deviation in various statistics as well as look at loss standard deviation as a stand-alone metric. A prominent example of the use of this concept is the Sortino Ratio, which replaces the standard deviation in the Sharpe Ratio with loss standard deviation in the denominator.

However, loss standard deviation numbers should be viewed with caution due to the limited data points involved with its calculation. Since all positive observations are ignored, the number of data points that are available may not be sufficient to make a valid statistical argument.