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Share Restrictions and Asset Pricing: Evidence from the Hedge Fund Industry by George O. Aragon November, 2004 JOB MARKET PAPER Abstract This paper finds a positive, concave relation between the retarns and share rostrictions of private investmest funds, and shows that previotasly doctunented poeitive alphas can be interpreted as coanpensation for hedding illiepud fund shares. The annaal retarns on funds with lockup provisions are appsoximately 4% higher than those for non-lockup funds, and the alphas of funds with the most liepud shares are either negative of insignificant. This paper alwo fiads a pooitive asociation betwren share restrictions and Illiquidity in fund assets, suggeating that funds facing high redemption costs use mstrictions to sereen for investors with low-liguidity acrds. The realts are consistent with previous theoties which posit that liquidity is priced, and that less liquid akets are beld by investors with longer investment horixoqis, JEL classification: G11;G12 Keywords: Liquidity; transactions costs; Hedge Fubds; Lockupo "I am sratrhal for the early and continurd suppott of my conamittes-Wayne Fersmi (chair), Piefluigi Baldumzi, Alan Marcus, and Jefl Pontiff, for the helpful conmeuts and susgentions of Ceakt Bekaert, Roger Edelen, and seminar participants at the JFE/Oregon Conference on Delrgated Portfolio Managemum, 200s FMA Doctoral Student Coasentiam, and Bonton College Brcws Bae Worknhop; for data provided lo HeclgeFund.brt and Vikas Agarwal abd Narayan Naik. Financial suppoet from the Foundation for Managed Derivatives Research is aratefully acknowledged. TFinance Department, Tbe Walluce E. Carroll School of Managemeat, Bostoa College, Chestat Hill, M.A 02467. Tel 1-617-053-1300 fax: 1-617-552-0131; e-mail: aragongabc.edu. Because of the limitation on redemption rights and the fact that interests in the Fund are not tradeable, an investment in the Fund is a relatively illiguid investurent and involves a high degree of risk, - Offering memomndum of a hedge fund company 1. Introduction In a sminal article, Amihtud and Mendelson (1986) develop a model in which assets differ in transactions costs and investors have different bolding periods. In equilibrium, financial markets exhibit a 'clientele effect,' where longer-horizon investors hold leas liquid assets, and the relation between expected returns and transuctions costs is positive and concave. 3 Subeequently, a number of cmpirical studies have tested the relation between asset returns and liuidity. These artiches have considered a variety of liquidity proxies, and focus mainly on the markets for publicly-traded chebt and equity. 2 We provide a direct empirical test of the relation betwonn asset returns and transactions costs, by considering share restrictions of private investaent funds (bereafter, bedge funds). Focising on transactions costs in this manuer provides a number of important advantages. In principle, share restrictions do not contain measurement error, since they are directly obervable from the fund's limated partaership agrecusent. This is to be contrusted with comparatively noisy liuidity proxies such as bid-ask spread, trading volume, or the estimated parameters of microstructare molels obtained from high-frequency data. The hedge fund industry ptowides an ddeal environment in which to exannime liquidity issues. Since budge funds may hold illiquid assets and face few limitations on the biquidity of their share agreenents, we expect signiticant variation in transenctions costs across funds. In contrast, mutual funds only charge investors a rodemption, ot, exit' fee, up to 8.5%. Moreover, while a substantial literature has addressed the performance of investment funds. very little is known about the role of investor beterogeneity in the matket for investment IReseazeb on the pricing of licquality gogs hack at kant to Keybes (1906), who defisen a liquility prenilum as, "the anoant which [people] are willing to pay for the potential convenience or security given try this power of tlisgooal (p.226)." See, also, Mayrrs (197a,1976), Levy (1976), and Coestantinides (1906). et al. (1998), Datar, et al. (1098), and Amilund (2002). fund shares. We investigate the possibility of a clientele effect, where longer-term investors hold shares with greater restrictions. 3 This analysis also has implications for recent studies suggesting that, in aggregate, hedge funds generate positive, after-foe exoess returns, of. "alphas." The poeitive alphas are interpreted as evidence of superior ability, possesced by the most talented portfolio managers, to systematically identify and profit from mispricing in one or many securities markets. However, it is unclear why superior managerial skill impbies higher after-foe performance, because better managers can simply charge higher fees. Moreover, much of the conventional analysis has ignored the fact that a typical bedge fund share is a relatively illiquid asset. 3 Share restrictions raise an important qquestion for the interpectation of hedge fund performance: Do hedge fund alphas represent abality, or simply a liquidity peemium? Using monthly data from 1994-2001, we document a positive, concave relationship between a fund's excoss returns and its tedemption notice period and minimum investment size. We also show that, in aggregate, the ditference in excess returns on lockup versus not-lockup funds, or, the "lockup premium," is about 4% per annum. This lockup premium is almost always positive acroes hedge fund style groups, though its magnitude exhibats urration acroess styles. The positive, concave relation between returns and share restrictions suggests that a 'clientele effect' exists in the market for hodge fund shares. Consistent with Amiluad and Mendelson (1986) (hereafter, AM). lese biquid shates provide higher returns, and are beld by investors with longer investment harizons. Strikingly, after controlling for lockup, notioe period, and mininum investment size, previonsty positive alphas are indistinguishable from zero. In fact, estimated fund alphas of the most liquid shares are either negative of insignificant. This provides an interesting complement to Edelen's (1999) analyxis of mutual funds, which shows that negative alphas reflect an indirect cost or, liquadity discount, due to liquidity-motivated trading of fund Hiquidhy costs on kang-term investocs within the same fund. "See, eg, Ackrrmaun et al. (1999). Liang (1999), Agarwal add Naik (2000), Harri and Blorsen (2002). "See Krishnab and Neiken (2003) and, "Nice Hedges, but Beware of Thotns," (HreinessWeel Online, December 27,1999 ), foe evidience of peactitiouer cobcern about shase restrictiveco. Akso, Asmeso, et al. (2001) and Getmanxky: of al. (2003) examine the eflicts of illiquidity expooure on roported returnac anul Aragon (2005) sbows that a bedge fund's marlort tinaing ahality is cocrelated with the ilinusidity exponsure of the fund's portfolio, investots. In contrast, we argue that the positive alphas of herlge funds represent a liqutidity preminm doe to trading restrictions imposed ot investors:" Other authors have exanimed measures of transactions costs in contexts that are roLated to hedge fund share restrictioss. For cxample, lppolito (1989) docuaents that imanal market-adjusted returns of load-type mutual funds are approximately 3.5% higher than that of no-load funcs, and Acloernama, et al. (1908) and Laang (1909) document a positive rolationshup betwren aggregate-level hedge fund returns and lockup provtsions. 7 . However, these authons neither focus on the effects of share restrictions on returns nor provide a direct test of the A.M theory: We also provide the first analysis of the croserectional variation in hedge fund share liquidity; that is, Why do some funds impose restrictions on their imvestors, while other funds do not? Frevions work builds on the AM model, and theorizes that share restrictions allow funes to screen fot investors with low-liquidity needs, which is-benedicial when share rodemptions are costly. Chordia (1966) ail Nanda, et al. (2000) examine mutual funds, and nodel redemption costs as the coets of trading the non-cash components of the fund's portfolbo. Thus, exit foes, or, the formation of Houl funds,' are mote conmon amoti managers that bold illiquil asects. More rocently, Lerner and Schoar (2003) model rexlemption costs as a 'hemoras problema.' They argue that a shert-temm invstor is more likely to force the: fund to raise aditional caprital from outsiders, who canmot chetermine whether this activity is due to an insader's liguality shock, or an insider's informed opinion that the fund is 'bad." Thas, share rextrictions are mote common among younger funds, where the lemons problem is mont mevere." Using cross-soctional data on bedse fund chazactaristics, we poovide empiricul siupport for the investot-serening theootis of Chordia (1996) and Lerner and Schoar (2003). Specilieally, lockups are more common among younger funds, and funds which hold more illiqual assets. We mukoe a distinction betwoxa a portfolio's average illiquidaty lecel versas its liquadity "an his conctuding remarks. Edeles (1999) notes, "... [hedge funde] might be expected to outperform an a result of this [liquadity] restriction (p.465)=" 'Elean et al, (1993) and Gruler (1506) arghe that Ippoclito'n resalt is doe to load finds' greater exposere to small stocks, which wo control for in the jresent study. Alop, see L.jungqviat asd Richanden (2000), who document that illiquid private equity stalos graerate excese returns of 5.8% per antuan. "Empleically, Choedia (1986) finds meme cvhence that load mestual funder hold a latger fraction of small stocks than no-load funds, while leruer and Schoar (2009) find, coksistent with the predictions of their 3 risk-the covariance of port folio returns with innovations in marlost liquadity. We coqsider the return-based smoothing model of Getmansky, Lo, and Makarov (2003), and find that bockups are positively related to the level of infrecument trading in a fund's holdings. However. lockups are tucorrelated with a fund's expoesure to liqquidity risk, whure market. liuidity is defined in the seno of either Pastor and Stambangh (2003) or Amahad (2002). Simce illiquid asoets aure associoted with high transactions costs, this result bighlights the relation between the liquixity of a fund's portfolio and its shares, and the mechanism through which fund managers conpensite investors for bearing share restrictions: An investor in a fund which holds an illiquid aseet captares at least part of the akest's illiqudity premaiam as compensation for the illiguidity of the fund. The remainder of the paper is organizod as follows: Soction 2 dawctsses hedge fund share restrictions, the data, and sumamary statistics, Socticn 3 presents ont makin rosults on the relation between share restrictions and returns; Section 4 addresses robustness; Section 5 stulieg the relation between lockup povisions and fund characteristies; and Section 6 concluches. 2. Hedge Fund Share Restrictions 2.1. Share Restrictions and transactions costs A typical hedge fand is organizod as a limited pattnership, the terms and conditions of whach are outhacd in the limited pautnership agroement. This agrocment is intendexi to provide material information about the fund to prospective investors, including the fund's fee structure and revlemption policy. The rexkemption policy often inolves either a lackup prowioion and/or a redemption notice period. A lockup provinion requires that all initial moties allocated to the fund may not be withdrawn before the end of a pre-specifiod daration. or, Eockup period. "The rechenption nothee period ts the ambotat of time the invator is requated to provide notice before redcemains his shares. Both of these restrictions contrast with the lieguidity of mutual funds which, on any business day, are legally required by the Investmucut Company Aet to satisfy an investor's share redemption request. TThe effretive lockup petiod anay he loacer, sibee some fusde vatiafy sedemptions oely at the cud of the calendas yeoz. For example, if the initial invrstment in Jaunary, 2002. is subject to a cae-year lockup, thru the earlirst fund redenaption may be at Decesber. D003. and the effective lodkap is two yearm. Hexlge fund share restrictions differ from most neastures of transictbons costs consdered in previous studues. Instevad of dollar transactions custs sach as bad-axk spreads, locktupo aud nottee periods impose time-dependent rules against share redemption. However, lockup provisions and notice periods may also be interpreted as exit fees, for the duration of the lockup and notice period, which are sufficicatly laigh to preclide an investor from selling the fund's shares. As in the case of bid-ask sprouds, the marginal impact of these costs hecormes swaller for longer-horizon investors, since these coots afe discounted over a larger investment horixon. Consexuently, our prexlactions are the sane as those of the AM thexry= the relation between returus and share restrictions is poeitive and concave. Theoretical work on the relation between share restrictions and returns is providerd by the growing literature on restricted ('letter') stock. Restricted stock is analogous to a lockup provision, since the bobder is subject to a minimum holding period. Longstaff (2001) and Kahl, et al. (2003) moelel the effects of restricted stock on an incetor's optimal port folio and consumption policies, and show that the implied value of restricted stock can range from 5090% of its market value. 10 Empirically. Wrtuck (1989) doctments that a 2-year restricted stock sells ut an wverage disount of 15% below unrestrictod stocks, while in Silber's (1991) sample the discount on restricted stock is about 35% Lippman and MeCall (198b) consder a time delay between a sell order and its execution. and argue that this case provides a taseful definition of liquidity, sinee illiquid assets are commonly viewed as those which cannot be immediately traded without cost. Koten and Sxeidl (2(W2) examine the impact of time delays on portfolio and consumption policies of an imvestor subject to randon liquidity shocks. They show that the effects of exccution delays can be signifocant, amd increase with the saze and intemsty of liguidity shocks, as well as the length of the time delay. Taken together, this evidenoe stiggests that lockups and notice periods can have significant effects on investors' utility and, ceteris paribus, illiquid hedge fuad shares shoubd offer higher rates of return. an uppes bound on the sumber of shares which ran be sold jer trading perind, and shows that the ligquidity discount can rakge from 1-25\%, depending upoe the luvestor's trailing hariann, the trading hounds, and the volatility of the illsquid asset's return volatility. "However, Hertzill and Smith (1995) argue that this discount is not entirely doe to a lack of markotabelity. but alsa rellects the coets burse ty outside invetorn in nosewise firm valse during a peivate placrurent

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