Abstract
The ability of hedge fund investors to exit a fund by exchanging ownership for cash at the prevailing NAV is often blocked by lockups and notice periods. We model the exit decision as a real option and incorporate lockups and notice periods as exercise restrictions. We compute the cost of these restrictions using a lattice that incorporates the possibility of fund failure. Using data through 2008, we estimate that a two-year lockup with a three-month notice period costs approximately 4% of the initial investment. The cost of illiquidity can easily exceed 5% per year if the hedge fund manager suspends withdrawals as was common in the months following the financial crisis.
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