Putting a Price on Flexibility: Reassessing Hedge Fund Lockups

When investors commit to a hedge fund with an extended lockup, it might seem like a small price to pay in pursuit of exceptional returns. After all, strong managers often say, “Trust us; we need the time and stability to execute our strategy.” But is that promise of outperformance worth sacrificing your flexibility?

That’s the question Emanuel Derman first posed back in 2007 and later refined in collaboration with K. Park and W. Whitt in 2009. At its core, Derman’s argument is simple yet powerful: locking up your capital means giving up the option to exit a struggling fund or reallocate to a better opportunity.Like any option, that ability to move your capital has value—and when you surrender it, you’re effectively paying a premium.

The Hidden Cost of Locking Up

It’s easy to overlook the cost of a lockup because it doesn’t appear as an explicit fee. Instead, the cost is hidden in the form of lost flexibility:

• Can’t Exit Underperformance – If your high-conviction pick falters, you might be stuck watching your capital languish.
• Can’t Rebalance Into Winners – A new, more attractive opportunity may arise, but your capital remains locked away.

Derman’s Markov chain models attempt to assign a dollar value to that lost flexibility by analyzing how capital flows might have changed under different market conditions. While investors don’t need to crunch the numbers themselves, they should recognize a fundamental truth: flexibility has value, and any time you relinquish it, you’re making an implicit trade-off.

Challenging Convictions

Investors often justify accepting a long lockup because they have “high conviction” in a manager’s ability to generate alpha. Yet, in the same breath, they may admit they lack the skill to pick the next top-performing manager—so they opt to stay put with the one they believe in.

But let’s consider the contradiction:

• If you have high conviction in this manager, it implies confidence in your ability to identify outperformers.
• If you have low conviction in your ability to pick managers, where does your certainty in this one come from?

This isn’t to say investors should avoid conviction, but rather that they should question its foundation. What specifically justifies the belief that this manager is worth the lockup? Is it past performance, strategy uniqueness, structural advantages, or something else? Derman’s framework encourages investors to understand the implicit trade-off they’re making when they surrender optionality.

A Framework for Better Decisions

You don’t need to run a Markov chain model every time you consider a lockup, but you should acknowledge the price you’re paying in lost flexibility. Here’s how Derman’s insights can help refine your decision-making:

• What if the manager underperforms?
• How often might you wish you could exit?
• How frequently do attractive new opportunities emerge?

• What is the basis of your conviction in this manager?
• Are you convinced by past performance, a differentiated strategy, or alignment of incentives?

2. Weigh Risk vs. Potential

• Lockups can be beneficial if the manager truly delivers alpha, especially if they prevent premature redemptions.
• But is that potential alpha worth the cost of missing out on future opportunities?

Final Thoughts

The discussion around lockups isn’t just about manager skill—it’s about understanding the hidden cost of giving up optionality. By committing to an extended lockup, investors are effectively paying a premium in the form of lost flexibility. Derman’s research highlights that this cost should be acknowledged, even if it’s not explicitly stated in fund terms.

Before signing up for a long lockup, ask yourself:

• Do I fully understand the trade-off between potential outperformance and lost flexibility?
• Am I confident in the reasons I believe in this manager’s skill?
• What’s the downside if things don’t go as planned, or if a better opportunity arises?

Every investment decision comes with a cost—sometimes it’s visible in fees, other times it’s buried in lost optionality. With hedge fund lockups, the cost is real, even if it’s not on paper. Make sure you know what you’re giving up—and decide whether it’s truly worth it.