8.3 General Remarks on the Management of Risk 319cretion. A high level of managerial discretion can help to mitigate the adverse ef-
fects of exit.
In particular, the firm can choose between funding that will have to be repaid
(such as debt) and payment obligations that give the firm more managerial discre-
tion (such as shares).
In a limited-liability company, the use of shares as a source of funding means
that exit will be constrained by legal rules that regulate the withdrawal of shares,
share buy-backs, financial assistance, the payment of dividends, and generally the
making of distributions to shareholders.
Equity technique. Generally, the equity technique can help to mitigate the risk
that the firm must make payments to investors when it needs funds the most. The
equity technique can be supported by mandatory provisions of law (such as com-
pany law provisions that regulate the distribution of funds to shareholders) or con-
tractual clauses (such as the terms of debt mezzanine instruments according to
which the repayment of debt is subject to restrictions).
Lock-up clauses. Contractual lock-up clauses can delay an investor’s exit from
the firm.
For example, a hedge fund or a private equity fund could ask investors to agree
to a lock-up according to which they must keep their money in the fund for a
minimum period. In a hard lock-up, investors have no right to redeem before their
time is up. In a soft lock-up, they can get out early but have to pay a redemption
fee of, say, 3%-5%. Most funds manage to bargain for one to two years. A five-
year lock-up would be unusual in that industry.^1
Lock-up clauses can also be found in IPOs. The fear of large-scale sales of
shares by other investors can depress share price. For this reason, the firm might
prefer to use a lock-up agreement with important investors (such as banks,
institutional investors and large shareholders) to limit the sale of shares during an
IPO process. If large investors must not sell their shares during a lock-up period,
the lock-up clause can signal to smaller investors that there will not be any
massive sales of shares just after they have subscribed for shares. This can reduce
perceived risk and encourage smaller investors to pay more for the shares.
For the firm, the benefits of lock-ups are clear. Lock-ups can help the firm to
match assets and liabilities. It would be riskier for the firm to invest, say, in an il-
liquid three-year project if the firm’s own investors could take their money back
within a year. Lock-ups can thus help the firm to invest in long-term assets or less
liquid assets. Lock-ups can also help to attract long-term investors by reducing the
risk that the investment project will fail after important investors have pulled out
at an early stage of the project.
A further benefit is that funding which is long-term because of lock-up clauses
can function as a functional equivalent to equity, act as a credit enhancement, and
reduce overall funding costs.
However, the drawback is that lock-ups generally increase the illiquidity of in-
vestments. They may keep out some investors.
(^1) All locked-up, The Economist, August 2007.