A hedge fund is open-ended: investors can join and leave over time, rather than committing for a fund's whole life as they do in private equity (PE101 2.1). But "open-ended" does not mean "whenever you like". Each fund's offering documents set out exactly when money can come in, when it can go out, how much warning is needed, and what the manager can do to slow withdrawals down.
These liquidity terms matter to almost everyone around a fund. Administrators process subscriptions and redemptions against them. Investor relations teams field questions when a gate is applied. Allocators at pensions, endowments and funds of funds need to know how fast they could get money back if their own plans change. This lesson walks through the main terms, using the Kessling Harbor Equity Long/Short Fund as the example.
Dealing dates and notice periods
A dealing date is a date on which investors can buy into or sell out of the fund at its net asset value (NAV) per share. Buying in is a subscription; selling out is a redemption.
- Subscriptions are commonly accepted monthly. The investor sends its subscription documents and cash before the dealing date and receives shares at that date's NAV.
- Redemptions are commonly allowed monthly or quarterly, and some funds deal less often still. The investor must give notice: a written request some time before the dealing date. Notice periods are often somewhere between 30 and 90 days, but terms vary widely.
Redemption proceeds are not paid on the dealing date itself. The administrator first has to finish calculating the NAV, so most of the money is usually paid within some days or weeks afterwards. When an investor redeems its whole holding, some funds hold back a small portion until the year-end audit is complete, then pay the balance.
Here is an illustrative timeline for Kessling Harbor, assuming quarterly redemptions with 60 days' notice:
| Step | Illustrative date |
|---|---|
| Investor submits redemption notice | By early November |
| Dealing date (redemption at that date's NAV) | December 31 |
| Most of the proceeds paid | During January |
| Any audit holdback paid | After the audit is signed off |
In this example, an investor who decides to leave in mid-November has missed the notice deadline and must wait for the March dealing date.
Lock-ups and early-redemption fees
A lock-up is a period after an investor subscribes during which it cannot redeem, or can redeem only at a cost. Lock-ups give the manager time to invest new money without worrying that it will leave quickly. The length varies from fund to fund.
- A hard lock-up means no redemptions at all during the period.
- A soft lock-up allows redemption during the period, but with an early-redemption fee, a percentage of the amount redeemed. The fee is usually paid to the fund, not the manager, to compensate the remaining investors for the cost of raising cash early.
Some funds offer share classes with different lock-ups: for example, a longer lock-up in return for a lower management fee (lesson 3.1 covers share classes).
Gates
A gate is a limit on how much can be redeemed on a single dealing date. It protects the fund, and the investors who stay, from having to sell too much too quickly.
A fund-level gate caps total redemptions across all investors, usually as a percentage of NAV. When requests exceed the cap, every redeeming investor is scaled back pro rata (in proportion to its request).
Suppose Kessling Harbor deals quarterly and has a fund-level gate of 25% of NAV per quarter. At one quarter-end, redemption requests total 40% of NAV.
| Step | Working | Result |
|---|---|---|
| Maximum paid this quarter | Gate | 25% of NAV |
| Share of each request paid | 25 ÷ 40 | 62.5% |
| Investor requesting $10m receives | 62.5% × $10m | $6.25m |
| Amount still outstanding | $10m − $6.25m | $3.75m |
The unpaid $3.75m is typically carried forward to the next dealing date. Whether carried-forward requests get priority over new ones, and whether the gate can apply quarter after quarter, depends on the fund's documents. Terms vary, so always read them.
Some funds instead use an investor-level gate, which limits how much of its own holding each investor can redeem on any one dealing date. For example, a fund might let each investor take out no more than a quarter of its holding each quarter. This spreads a large investor's exit over time whatever other investors do.
Side pockets and suspensions
A side pocket is a separate account within the fund for assets that are hard to value or sell, such as a stake in a private company or a security that has stopped trading. The asset is moved out of the main portfolio, and investors at that time receive a matching interest in the side pocket.
- Investors can redeem their ordinary shares as normal.
- Their side-pocket interest cannot be redeemed. It is paid out only when the asset is realized, meaning sold or otherwise turned into cash.
- New investors don't share in existing side pockets.
This means redeeming investors aren't paid out at an uncertain estimate, and newcomers don't buy into it. The drawbacks are that investors can wait a long time for their money, and side-pocket assets are still valued by the manager, so investors will want to know how. Management fees on side-pocketed assets are a point to check.
A suspension goes further. In extreme situations, such as when the fund cannot value its assets reliably or a market has closed, the fund's board may suspend redemptions (and usually NAV calculation and subscriptions) altogether. Suspensions are meant to be rare and temporary, and the offering documents set out when they are allowed.
Matching terms to assets
The central idea is the same one PC101 4.2 calls a liquidity mismatch: a fund promising investors more liquidity than its assets can provide. If investors can leave faster than the manager can sell assets at fair prices, the fund may have to sell the most liquid holdings first or accept low prices. Those who stay end up with a weaker, less liquid portfolio.
So liquidity terms should broadly fit the strategy:
| Strategy | Typical assets | Terms that fit |
|---|---|---|
| Equity long/short in large listed companies | Shares that trade daily | Relatively frequent dealing, such as monthly or quarterly |
| Managed futures | Exchange-traded futures | Often frequent dealing |
| Distressed debt | Loans and bonds that trade rarely | Longer notice, lock-ups, gates and possibly side pockets |
These are illustrations of fit, not rules. Allocators also look at the other side: how quickly the fund could actually sell its positions in normal and stressed markets, and whether the terms have enough protection for a bad quarter.
Key terms
- Dealing date: a date on which investors can subscribe to or redeem from the fund at NAV.
- Notice period: how far ahead of a dealing date a redemption request must be submitted.
- Hard lock-up: a period after subscribing during which the investor cannot redeem.
- Soft lock-up: a period during which early redemption is allowed, subject to an early-redemption fee.
- Gate: a limit on redemptions on a single dealing date, set at the fund level or the investor level.
- Side pocket: a separate account for illiquid or hard-to-value assets, paid out only when those assets are realized.
- Suspension: a temporary halt to redemptions, usually with NAV calculation, in extreme circumstances.
- Liquidity mismatch: when a fund offers more liquidity than its assets can provide.
Key takeaways
- Hedge funds are open-ended, but investors can only leave on dealing dates, after notice, and sometimes only after a lock-up.
- A fund-level gate scales every request pro rata: with a 25% gate and 40% of requests, a $10m request receives $6.25m and the rest waits.
- Side pockets and suspensions deal with assets that cannot be valued or sold, at the cost of delaying investors' money.
- Terms should fit how liquid the fund's assets are. Read the documents, because liquidity terms vary widely between funds.
This lesson is for educational purposes only and is not investment advice.