Deep inside most private equity portfolios lurk funds that have little hope of turning a profit, yet they still feed on the resources of institutional investors — and there's not much investors can do about it.
They're called “zombie funds” and they're a dirty little secret of private equity investors and consultants, dwelling in the bottom quartile of private equity portfolios.
In a recent survey by Coller Capital Inc., London, a private equity firm that invests in the secondary market, two-thirds of investors worldwide indicated they have zombie funds, the informal term used for funds that are practically dead but still charging fees until their lives expire. These funds have little hope of making money, or have made money but still have one or two holdings that can't be sold.
Industry experts estimate as much as $100 billion of the roughly $2.4 trillion in private equity could be invested in zombie funds.
And these funds are multiplying. Already, a number of venture capital funds raised in 1999 and 2000, especially those formed to invest in Internet-related companies, can be classified as zombie funds. And in three to five years, industry insiders expect more private equity funds that were raised just before the 2008 credit crisis to join the ranks of the living dead.
Zombie funds can be a real problem for money managers, who will have a tough time persuading investors to commit capital to a new fund when those investors are taking a hit on the zombie fund, insiders say. Investors face the unsavory choice of rounding up enough fellow limited partners to shut down the fund and take a share of the portfolio companies instead of cash, or receive a management fee reduction for allowing the manager a one- or two-year extension to bring the fund back to life.
Portfolios containing zombie funds also are difficult to monetize, which affects returns and creates administrative burdens as these funds need to be monitored, said Mario L. Giannini, CEO of Hamilton Lane, a Bala Cynwyd, Pa.-based alternative consultant and money manager. It also slightly reduces available capital because limited partners count zombie net asset value as capital allocated to private equity.
The existence of zombie funds has not changed how investors invest, yet.
“If these funds are not liquidated and continue to increase in number, LPs will question why it makes sense to allow GPs to hold their capital for 15 or 20 years like that,” Mr. Giannini said.
And zombie funds are everywhere.
“Unfortunately, most mature private equity fund portfolios that have been around a few business cycles have some zombie funds,” said David I. Fann, president and CEO of TorreyCove Capital Partners LLC, a La Jolla, Calif.-based private equity consulting firm formerly known as PCG Asset Management.
“We believe at least 10% of funds raised in any given vintage year won't return all of the invested capital,” he said.
In Coller Capital's Global Private Equity Barometer, which measures private equity investing trends, the proportion of investors saying they're saddled with zombie funds is greatest in North America. According to Coller's latest survey conducted in August and September, 57% of North American limited partners responding to the survey indicated they have zombie funds in their portfolios. Half of institutional investors in the Asia-Pacific region said their private equity portfolios are infested with zombie funds, and 41% of European limited partners have zombie funds.
“Zombie funds are certainly frustrating for investors,” said Frank Morgan, partner in the New York office of Coller Capital. “Not only won't they get returns, but the manager is behaving in its own self-interest to keep the fund going to get the management fee.”
And the specter of zombie funds isn't just haunting tiny, unknown firms. Brand-name private equity firms also are managing zombie funds, according to sources, among them Stonington Partners Inc. (formerly Merrill Lynch Capital Partners Inc.), Forstmann Little & Co., Fenway Partners and Thomas Weisel Partners Group Inc., which was acquired by Stifel Financial Corp. in 2010.
Fenway Partners and Forstmann Little officials declined to comment, said Jonathan Doorley, spokesman for both firms. Alexis P. Michas, managing partner of Stonington Partners, and Linda Olszewski, a spokeswoman for Stifel, could not be reached by press time.
Many of these zombie funds had A-list investors. For example, the $222.5 billion California Public Employees' Retirement System, the $115.2 billion New York City Retirement Systems and $56.4 billion Oregon Public Employees Retirement Fund are Fenway Partners investors. Oregon PERF also is an investor with Thomas Weisel and Stonington.
James Sinks, spokesman for the Oregon Investment Council, which manages the Oregon fund, noted that the council made a $100 million investment in Thomas Weisel's 1999 fund and the fund returned $61.3 million, resulting in a -9.4% internal rate of return as of Sept. 30. Oregon received a $20.7 million distribution from its $66.6 million investment in Fenway's third fund made in 2006. The IRR was -7.9% at the end of the third quarter. Mr. Sinks could not provide further comment by press time.
Lives of their own
Zombie funds, like their horror-movie namesakes, are hard to kill, Mr. Fann explained. They won't go away easily because either some portfolio companies might have some hope of providing returns “or, perhaps more cynically, a rationale to justify management fee income for general partners who can't move on,” Mr. Fann said.
The options are less than ideal, he said. According to Mr. Fann, some of the alternatives commonly discussed include:
- accept lifespan extensions in return for a lower or no management fee and a defined path to winding down the fund;
- don't accept an extension and cause the fund to distribute the remaining assets;
- sell the fund in the secondary market for a steep discount; or
- remove the general partner and recruit a replacement general partner to manage the wind-down of the fund.
Hard to kill
Investors are loath to pursue many of these options. “The practical reality is that there are no good alternatives and it is hard for anyone to herd together multiple limited partners to take an adverse stance against a general partner of a fund,” Mr. Fann said.
Adding to the zombie dilemma is that even healthy funds have trouble wrapping up within the typical 10-year span. Most need to seek one or multiple extensions.
Indeed, some of the hottest funds from years past allowed managers to extend their fund lives without investor approval. Even zombie fund managers that require approval of investors often are given the nod to extend the fund's life.
Why not just kill the funds? One reason is that investors do not want the liquidated assets delivered to them, he said. “They often will default to extend, maybe without any management fees,” Coller's Mr. Morgan said.
“There are not a lot of wind-downs,” Mr. Morgan said. “It's very hard to kill a private equity fund until it runs out of oxygen.”