## **Learning Outcomes**

This article explains how to assess liquidity, gearing, and lockup structures in investment vehicles, including:

- distinguishing between fund-level and asset-level liquidity, and relating redemption terms, notice periods, gates, and suspension rights to actual access to capital;
- defining key terminology such as liquidity risk, gearing, lockup periods, hard and soft lockups, and redemption frequency in the context of pooled vehicles;
- analyzing how gearing, margin, and embedded gearing alter volatility, downside risk, and the potential for forced asset sales;
- evaluating how combinations of notice periods, lockups, and gate provisions manage redemption pressure and protect remaining investors in stressed markets;
- interpreting worked examples that calculate effective liquidity horizons, gating impacts, and maximum exposures under specified gearing limits;
- applying a due-diligence mindset to fund documents by identifying structural terms that materially affect investor liquidity, risk, and expected holding period for CFA Level 1 exam-style questions, and articulating the implications for portfolio construction and client suitability.

## **CFA Level 1 Syllabus**

For the CFA Level 1 exam, you are expected to understand how the structure of investment vehicles influences risk, liquidity, and redemption flexibility, with a focus on the following syllabus points:

- Define and identify liquidity risk and structures (e.g., redemption and lockup restrictions) in investment funds.
- Explain the effects of gearing at both the asset and fund level, including when and how gearing increases risk for investors.
- Compare the structural provisions (e.g., lockups, gates, redemption frequency) used to manage liquidity and redemption risk.
- Analyze the due diligence process for assessing fund structures, including the implications for investor liquidity and exit.

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is the main purpose of a lockup period in an investment fund?
2. How does the use of gearing by an investment fund affect investor risk?
3. Which provision allows a fund manager to temporarily restrict all withdrawals from a fund for all investors when redemption requests exceed a specified limit?
4. In what way does the structure or terms of a fund affect the liquidity risk faced by individual investors?

## **Introduction**

Investment vehicle structures play a significant role in determining the liquidity, gearing, and redemption rights available to investors. Due diligence on these features is essential to understanding both the risks assumed and the protections in place. This article examines the practical and exam-relevant consequences of liquidity features, gearing, and structural lockups for CFA Level 1 candidates.

## Liquidity in Investment Structures

Liquidity refers to an investor’s ability to buy or sell fund interests or portfolio assets without causing significant price movements or waiting periods. In the context of pooled investment vehicles, such as hedge funds, private equity, and open-ended mutual funds, liquidity is determined both by the liquidity of the fund’s assets and by the structural provisions defining when or how investors may redeem their investments.

> **Key Term: Liquidity risk**
> The risk that an investor or fund will not be able to sell investments or withdraw money on demand, often due to asset illiquidity, structural restrictions, or adverse market conditions.
>
> **Key Term: Redemption notice period**
> The minimum time required between when an investor requests a withdrawal and when the fund will actually process and pay the redemption.
>
> **Key Term: Redemption frequency**
> How often an investor is allowed to redeem shares/interests in a fund, such as daily, monthly, or quarterly.

### Structures Influencing Liquidity

Common mechanisms that restrict or shape investor liquidity include:

- **Notice periods:** Investors must give advance notice (e.g., 30, 60, or 90 days) before redeeming.
- **Redemption frequency:** Some funds only permit redemptions at set intervals (e.g., monthly, quarterly, or annually).
- **Gates:** Manager-imposed limits on the proportion of fund assets that can be redeemed during a given period.

> **Key Term: Gate provision**
> A structural limit that restricts the amount or percent of total fund assets that investors can collectively redeem in a single period, safeguarding against excessive withdrawals.
>
> **Key Term: Lockup period**
> A pre-agreed period, typically at the beginning of a fund investment, during which redemptions or withdrawals by investors are not permitted.

Fund managers implement these restrictions to allow the fund to manage assets efficiently without being forced to sell illiquid holdings at distressed prices, thereby protecting the collective interest of investors.

### **Worked Example 1.1**

**A global macro hedge fund holds mainly liquid futures and fixed income, allowing monthly redemptions with 30-day notice, but installs a 20% annual gate on withdrawals. What is the maximum an investor can redeem if all investors request withdrawals totaling 25% of the fund this year?**

> **Answer:**
> At most 20% of the fund’s assets can be redeemed by all investors in aggregate in the year; the manager may use the gate to restrict redemptions exceeding this level. Each investor’s redemption will be prorated.

## Gearing Structures and Associated Risks

Gearing refers to the use of borrowed funds or derivatives to increase exposure beyond the value of the invested capital. Gearing magnifies both gains and losses, increasing the risk profile of investments at both the asset and fund level.

> **Key Term: Gearing**
> The process of using borrowed money, derivatives, or margin to increase an investor or fund’s market exposure. Gearing increases returns in rising markets but also amplifies losses in downturns.

Funds using gearing may have higher volatility, risk of margin calls, and even potential for loss beyond initial investment. For investors, it is critical to analyze not only headline gearing ratios but also whether legal documents permit the use of gearing and under what conditions.

### Gearing and Portfolio Effect

For pooled vehicles, gearing may be reflected in:

- Direct borrowing by the fund (e.g., bank loans, margin accounts).
- Embedded gearing in derivatives (e.g., long/short swaps, futures, options).
- Gearing at the asset level (e.g., property companies with mortgage debt).

Funds with significant gearing can be forced to liquidate positions quickly if asset values fall, potentially impacting all investors in the fund.

### **Worked Example 1.2**

**A fund is permitted to use gearing up to 2:1. If an investor contributes \$1 million, what is the total market value of assets the fund may control?**

> **Answer:**
> With 2:1 gearing, the fund may borrow \$1 million in addition to the \$1 million in investor capital, controlling assets of up to \$2 million total.

### **Exam Warning**

> A common misreading is to assume that all fund assets are equally liquid or that redemption rights guarantee fast returns of capital. In illiquid markets or stressed periods, funds can suspend redemptions beyond stated notice periods or gates to prevent disorderly asset sales. Read fund documents carefully to verify the actual liquidity risk, not just the standard redemption schedule.

## Lockups and Structural Redemption Risk Controls

A lockup restricts investor redemptions for a defined period after investment. Combined with notice periods and gate provisions, lockups help manage liquidity mismatches and protect remaining investors from sudden asset sales forced by large redemptions.

- **Hard lockup:** No redemptions allowed for a fixed period, usually 1-3 years.
- **Soft lockup:** Investors may redeem before a certain period but must pay a penalty or fee for early exit.

> **Key Term: Hard lockup**
> A strict prohibition on any investor withdrawals for a predetermined period, with no exceptions.
>
> **Key Term: Soft lockup**
> Allows early redemptions before the end of a specified period but imposes a penalty or exit fee, usually to discourage withdrawals.

### Rationale for Lockups and Investor Considerations

Fund managers may implement lockups when holding illiquid assets or pursuing a long-term investment strategy. The presence of lockups aligns with the time horizon required to realize gains from less liquid or private investments.

Investors must assess:

- The impact of lockups on their own liquidity planning.
- Penalties for early withdrawal under soft lockups.
- The relation between lockups and expected return—longer lockups are often offered in exchange for higher potential returns.

### **Worked Example 1.3**

**You invest in a private credit fund with a 2-year hard lockup and quarterly redemption opportunities thereafter with 90 days’ notice. When is the earliest you may redeem, and how might the fund respond if redemptions surge after the lockup ends?**

> **Answer:**
> The earliest redemption is after 2 years, subject to the fund’s quarterly redemption schedule and 90-day notice. If redemption requests are high—especially if asset sales would be required to meet withdrawals—the fund may activate a gate provision, temporarily restrict redemptions, or suspend withdrawals beyond the standard process.

### **Revision Tip**

> When reviewing fund terms, construct a timeline reflecting the minimum investment horizon, redemption frequency, notice period, and any possible extension from gates or suspension provisions. Use the strictest combination as your working assumption for maximum redemption time.

## Assessing Structures in Due Diligence

Due diligence requires a thorough analysis of fund documentation and legal structures, including:

- Organizational documents outlining permissible gearing and liquidity management tools.
- Offering memoranda and side letters spelling out any exceptions, fee structures, or penalties.
- Historical experience with redemption restrictions or suspensions during stressed market periods.

Focus exam revision on the ability to:

- Distinguish between different liquidity and lockup features.
- Identify where gearing is taken and how it changes investor risk.
- Assess consequences of gates, lockups, and redemption suspensions for both individual and collective investors.

## **Summary**

Understanding the interplay of liquidity, gearing, and lockup structures is fundamental to risk due diligence. Liquidity provisions such as redemption frequency, notice periods, and gates determine how quickly investors can access their capital. Gearing amplifies both returns and risk, requiring careful analysis of not only the permitted levels but also triggers for margin calls and forced liquidations. Lockup periods and redemption suspensions are key structural devices to control withdrawal risk and protect fund integrity during periods of stress.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and apply the meaning of fund liquidity, liquidity risk, and relevant structural provisions.
- Identify how gearing magnifies risk and understand the structural forms and limits of gearing in collective funds.
- Explain lockup periods, gates, and redemption notice periods, and how they restrict or delay investor withdrawals.
- Evaluate the impact of liquidity, gearing, and lockup structure in the due diligence process for CFA Level 1.

## **Key Terms and Concepts**

- Liquidity risk
- Redemption notice period
- Redemption frequency
- Gate provision
- Lockup period
- Gearing
- Hard lockup
- Soft lockup

Risks due diligence and structures - Liquidity leverage and lockups