Summary - When a company makes the decision to go public, they frequently register for an initial public offering (IPO) as a way to raise private equity. In the IPO prospectus, these companies will frequently include a clause that specifies a lock-up period and subsequent lock-up period expiration date. During the lock-up period, individuals that bought shares during the IPO process are prohibited from selling their shares on the secondary market for a period of time that typically ranges from 90 to 180 days. A hedge fund may institute a similar lock-up period and lock-up period expiration to allow a fund manager to generate a large return without concern of capital leaving the fund.
Although proponents of market timing pay close attention to IPO lock-up period expirations as an opportunity for both long and short sellers, there is a vocal group that argues against the need for lock-up periods at all. These proponents of the Efficient Market Hypothesis (EMH) argue that an efficient market will take into account information related to a stock and that the market is constantly accounting for that information in the share price. The theory goes on to express that any new information is immediately factored into the stock price, thus eliminating the opportunity for an individual or institutional investors to time the market. Any abnormal stock return can occur only through investing in higher risk stocks.
For a company or hedge fund to go public, they have to raise private equity. For a hedge fund, this includes inviting investors to invest in the fund and for private companies, this typically takes place by the issuance of an initial public offering (IPO). In both cases, however, there is a significant risk of unfavorable price movement if investors were to pull their money out of the fund or stock too quickly. This is why most hedge funds and IPOs include a lock-up period. During this period, investors and shareholders are prohibited from buying and selling shares. The lock-up period expiration, therefore, is a closely watched event for investors who are following IPO stocks because the period around the lock-up expiration is usually marked by high trading volume and significant price movement. This article will go into detail about what a lock-up period is and how it is different for a hedge fund as opposed to an initial public offering. The article will also review why they are needed if they are legally required, how they differ from the quiet period expiration date, and perhaps most importantly – and controversially – do they really work?
What is a lock-up period?
A lock-up period (also known as a lock-up agreement) is a period of time (usually between 90-180 days) when investors are not allowed to buy or redeem shares. Lock-up periods can apply to hedge funds and initial public offerings. A hedge fund lock-up period will be linked to the underlying investments of the fund. If a hedge fund is comprised of mostly stocks with high liquidity, there may be a short lock-up period of 90 days. If the fund is considered to be more distressed (i.e. it is invested in low volume securities such as loans or other forms of debt), they may have a much longer lock-up period. Once the hedge fund lock-up expiration passes, investors can redeem shares according to the schedule laid out by the hedge fund. However, investors are generally required to give 30- to 90-day notice. This is to allow the hedge fund manager to liquidate underlying securities as needed. Each investor’s lock-up period expiration is tied to the date they began investing with the fund. This limits the amount of liquidation that can take place at one time.
An IPO lock-up period is a clause written into the prospectus of a company that accompanies its initial public offering (IPO). The lock-up period prohibits company insiders and other individuals who purchased stock as part of the IPO from selling their ordinary shares on the secondary market. Once the lock-up period ends (a date known as the lock-up period expiration), those shareholders can buy and sell their ordinary shares as they please.
Why is a lock-up period needed for a hedge fund?
The lock-up period is needed in order for hedge fund managers to attempt to maximize the return for investors. This can happen because, during the lock-up period, they can make an investment in securities that support the fund's goals without having to be concerned about investors redeeming shares. Without a lock-up period, the fund manager would have to ensure there was a large amount of cash or cash equivalents available which would take away from the available money to invest, thus lowering the potential return.
Why is a lock-up period needed for an IPO?
The theory behind an IPO lock-up period is that company insiders (which includes a company’s founders/owners, managers and employees) usually own a volume of shares that is disproportionate to the general public. After the initial public offering, these insiders – which can also include institutional investors, venture capitalists, and other early investors – have the most to gain from selling their shares at the higher share price created by the IPO.
If investors who bought shares of stock during the IPO were to suddenly share their shares when the stock began publicly trading, it would force the stock price down as more total shares outstanding enter the market. This increase in negative trading volume could have a long-term impact on the stock because it may curb the appetite of potential investors.
Some economists, particularly those who promote an efficient market, question if there is enough empirical evidence to support the need for a lock-up period. However, they have become a de facto clause in the prospectus for every IPO stock. The most common reasons for having a lock-up period (and a defined lock-up period expiration) include:
- It provides a period of time to "bridge the gap" created by information that is available to insiders prior to the IPO but is not available to the general public until after the IPO. In some cases, certain company insiders may have to wait for a period of time after the lock-up period expiration to sell their shares. This can occur during a company’s earnings season because insiders may have access to information about the company that could be construed as insider trading in the event that they were to sell their shares.
- It is sometimes thought of as a way for a company to create a signal regarding the quality of its stock. From Wall Street to main street, perception is reality. Most company insiders and early investors are simply looking to reward themselves with the profit that comes from taking their company public. However, to the public, this insider selling happening immediately after the initial public offering could appear to be a sign that the company is in trouble.
Are company’s legally required to set lock-up periods?
The short answer is no. In fact, a lock-up period is not required by any regulatory body including the Securities & Exchange Commission (SEC). However, they have become an almost de facto standard that is either self-imposed by the company who is launching the initial public offering or is required by the investment bank that is underwriting the IPO.
How is a lock-up period expiration different from a quiet period expiration?
Although both the lock-up period expiration date and the quiet period expiration date are used to help prevent abnormal stock returns, they happen at different times in the IPO process. The lock-up period expiration must be reached before selling activity can take place, the quiet period expiration date must be reached before buying can take place. The IPO lock-up period starts after the initial public offering is complete and goes into effect for a period of time while ordinary shares are sold on the stock exchange. The IPO quiet period takes place before the initial public offering is issued. This is a time when management and marketing teams from the company releasing the IPO are prohibited from releasing news to the public. Part of this is to prevent the real or perceived appearance of insider trading.
Do lock-up periods work?
This is a hotly debated topic within the investment community. The debate centers around the Efficient Market Hypothesis (EMH) theory. The EMH theorizes that a company’s share price reflects any and all information about the stock. Therefore, stocks will always trade at their fair value on their respective stock exchange. Proponents of the EMH would state that fundamental and technical analysis cannot be used to generate abnormal stock returns. They claim the only way to get higher returns is to purchase securities and investments that contain more risk.
According to the EMH, the lock-up period expiration is a matter of public record in the prospectus released with the IPO. With that in mind, an efficient market will take this expiration date into account before it actually happens. For example, if Company XYZ issues an IPO with a 90-day lock-up period expiration, the EMH would theorize that institutional investors and venture capitalists will automatically digest the knowledge of the IPO lock-up expiration date and initiate trading to move the share price accordingly. That way, when insider selling takes place after the lock-up expiration date occurs, the price impact will be negligible.
There is a semi-strong and a strong form of the EMH theory. The semi-strong form defines known information to be “all publicly available information”. This means that any individual can profit from that information because it is already in the public arena. The price impact of any new public information will be reflected in the company’s stock price almost immediately so a trader would have a difficult time profiting from that information. The semi-strong form would state that a lock-up period expiration date falls into the category of “publicly available information” and therefore would be incorporated into the stock price. Based on the semi-strong theory, the only way for an investor to generate higher stock returns would be to have information available to them before it became public.
The strong form defines known information to be “all pertinent information, both public and hidden”. Proponents of the strong form would claim that it was not possible for investors to generate abnormal stock returns even if they were trading on insider information.
On the other end of the argument are those investors who believe in market timing as a way to select stocks that will outperform the market. For these investors, the lock-up period expiration date becomes an ideal tool to time the market and attempt to profit during a period with either long or short selling techniques based on the anticipated price movement.
The final word on lock-up period expiration
A lock-up period expiration date can be a significant event for investors who believe in the benefits of market timing. At the end of a lock-up period, there can be significant share price movement and higher trading volume as company insiders (which includes company founders/owners and executives as well as institutional investors and venture capitalists) look to take profit after being prohibited from selling shares during the lock-up period.
A lock-up period is also frequently assigned to hedge funds. This is done so the hedge fund manager can initiate trades in accordance with the fund’s objectives without being concerned about the fund having a flight of capital from investors.
Although lock-up periods are not a legal requirement they have become a de facto standard that a company will issue voluntarily or to comply with the underwriters of the IPO. In either case, the lock-up period in an effort to protect the share price from the significant downward price movement that can occur when the early investors dump their shares. It also serves to prevent any appearance of insider trading.
The idea of using lock-up expiration dates as a form of market timing to generate abnormal stock returns is widely debated in the industry. Proponents of an efficient market use the Efficient Market Hypothesis (EMH) to claim that the market takes into account all publicly known information or any information both public and private into the stock price. Therefore, these investors would claim that the share price of an IPO stock is already pricing in the lock-up period expiration and subsequent activity surrounding it.