What are the liquidity considerations when investing in Alternative Investments?
Alternative Investments typically require longer-term capital commitments than traditional investments because they often invest in less liquid assets. As a result, these strategies may require defined holding periods or limit when capital can be redeemed. Understanding how and when you can access your money can help you plan for liquidity needs and avoid unexpected constraints.
Published by the Investment Solutions Group | Alternative Investments Team
Key takeaways
- Alternative Investments are usually designed for long-term investors, with strategies focused on multi-year growth and value creation rather than short-term results.
- Funds typically require longer-term commitments, and you may not be able to access your money immediately.
- This allows access to longer-duration investment opportunities, with many strategies including lock-up periods.
- Redemption windows define when you can request redemptions, often monthly, quarterly or semiannually, sometimes with advance notice required.
- Gates may limit how much capital can be redeemed at once to help protect the strategy and investors.
- Planning for liquidity needs is an important part of incorporating these strategies into a broader portfolio strategy.
Why Alternatives work differently
Alts are generally designed for long-term investing. Many managers invest in assets that take time to mature or implement investment strategies that cannot be sold or adjusted quickly without potentially risking sales at unfavorable prices, particularly during periods of market volatility.
For this reason, many strategies restrict redemptions as a natural byproduct of investing in more complex, less liquid assets. These liquidity provisions help fund managers:
- Pursue long-term investment strategies without having to react to short-term investor activity
- Avoid selling assets at unfavorable times
- Focus on creating value over the intended investment horizon
In exchange for reduced access to their capital, investors may benefit from an illiquidity premium, which refers to the potential for higher long term returns as compensation for holding investments that cannot be quickly converted to cash without potentially affecting value. Specific redemption terms vary by strategy and are outlined in the offering documents.
Understanding the redemption process
NOTE
Submitting a redemption request does not necessarily mean investors will receive cash immediately. Redemption requests are typically processed according to specific redemption terms, which may include scheduled redemption windows and advance notice periods.
The timing and amount of any proceeds received can vary based on the strategy, overall redemption activity and available liquidity in the current market environment. Investors may receive their full redemption request, a partial amount if limits apply with cancellation of the remainder of the request if a fund limit has been exceeded, or for certain investor-level gates – have the request carried forward to a future redemption period.
In some cases, investors may also incur fees for redeeming early, while other strategies may limit or suspend redemptions during certain periods, such as a fund wind-down or full-life lock-up.
How liquidity varies by Alternative Investment structure
Less liquid:
Drawdown funds, commonly used for private markets strategies such as private equity, venture capital, infrastructure and real estate
- Lock-ups last years (usually the full fund life)
- No regular redemption windows
- Access only at distributions/harvest events, by design so managers can pursue long-term value creation
- Illiquidity premium is a component of compensation
Periodic liquidity with restrictions:
Evergreen (perpetual) funds, such as interval funds, registered and unregistered hedge funds, non-traded real estate investment trusts (NTRs) and non-traded business development companies (NTBDCs)
- Often offer:
- Shorter lock-ups (ranging from several months to multiple years)
- Redemption windows
- Tender offers and share repurchases
- Most evergreen (perpetual) funds use soft lock-ups, allowing earlier redemption subject to a declining fee, rather than a hard lock-up that prohibits redemption entirely
- Provide some flexibility while still pursuing longer-term strategies
Lock-up periods: The initial commitment
NOTE
Lock up periods give fund managers the flexibility to pursue longer-term investment opportunities without needing to manage frequent redemption requests. During this initial period after an investment is made, investors generally cannot redeem capital.
The length of a lock-up period depends on the structure. In many drawdown funds, the lock-up period may extend throughout the life of the fund. Evergreen (perpetual) funds typically have shorter lock-up periods, ranging from several months to multiple years depending on the product.
After a lock-up period expires, investors may be eligible to redeem capital during scheduled redemption or tender windows.
Some strategies use soft lock-ups instead of, or following, a hard lock-up period. Under a soft lock-up, investors may redeem earlier but typically pay a fee or penalty that often declines over time and eventually expires. This structure discourages early redemptions while preserving a degree of flexibility.
Redemption windows: How and when to make redemptions
After any applicable lock-up period ends, investors may be able to request redemptions during scheduled redemption windows. The timing of these windows can vary but tend to occur monthly, quarterly or semiannually.
Many funds require an advance notice period, often 30 to 90 days, to give managers time to plan liquidity needs and make any necessary portfolio adjustments. Redemption instructions vary by product. Some may be provided verbally to your Merrill advisor, while others require a signed document or form. Note that the notice period (how far in advance you must submit a request) is separate from the redemption window (how often requests are accepted).
Some strategies may also offer other ways for investors to access capital, such as tender offers and share repurchase programs. When available, these options tend to occur periodically, may be limited in size and may not fully satisfy all redemption requests.
For illustrative purposes only
Gates: When funds limit redemptions
NOTE
Gates are limits on the amount of capital that can be redeemed during a given period. They are designed to help the fund manage liquidity and protect remaining investors from having to sell assets too quickly or at unfavorable times when redemption requests are unusually high.
Gates can apply at various levels, depending on the fund structure.
- Fund-level gate: Limits the total amount that can be redeemed across all investors in the strategy during a given period. For example, a 25% fund-level gate means only 25% of the fund's total assets can be redeemed during a period, no matter which investors are requesting redemptions.
- Share class/feeder fund-level gate: Applies to a group of investors within a particular share class or feeder fund. For instance, a 25% gate for all investors in a specific feeder fund means only 25% of that specific group's total investment may be redeemed per period.
- Investor-level gate: Limits redemptions for individual investors. A 25% investor-level gate would allow individual investors to redeem up to 25% of their own investment in each period.
If a redemption request exceeds an applicable gate, funds may process redemptions partially on a proportional basis. As is common with fund-level and share class-level gates, the product may require a new redemption request be submitted during the next window, but resubmission requirements ultimately depend on each fund's terms.
Planning for your liquidity needs
Liquidity considerations are most effective when viewed across the entire portfolio. More liquid assets can help meet short-term cash needs, while strategies with liquidity constraints are generally better suited for long-term wealth objectives.
When evaluating liquidity:
- Consider how much capital you may need access to on a regular or immediate basis
- Assess how long other assets can remain invested or committed
- Plan for capital calls by maintaining sufficient liquidity to meet future funding obligations
- Align allocations with broader cash flow and spending needs
Your Merrill advisor can help analyze your overall liquidity profile and design a portfolio strategy that balances flexibility with long-term growth.
What this means for you
Alts can play a valuable role in long-term portfolio growth, but they are designed with a different approach to liquidity than traditional investments. Understanding lock-ups, redemption windows and gates can help you plan ahead and avoid surprises. With thoughtful liquidity planning and the right mix of assets, these strategies can play an important role in a broader portfolio strategy, while preserving more liquid assets elsewhere in the portfolio for near-term cash needs.
Alternative Investments are speculative and involve a high degree of risk.
Alternative Investments are intended for qualified investors only. Alternative Investments such as derivatives, hedge funds, private market offerings, and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in Alternative Investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk.
When considering the appropriateness of mutual funds or Alternative Investments, please be aware that there are significant differences between these investments which will cause their investment portfolios, performance, tax treatment and other factors to differ. These differences include the types, availability and diversity of securities that can be purchased, economies of scale, regulations and other factors applicable to their management.
