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End may be near for zombie private equity funds

Limited partners turn to secondary market to kill problem portfolios

061013 giannini
Mario Giannini believes one solution, albeit a tough one, would involve changing general partners.

Investors are starting to see the emergence of end-of-life solutions for the zombie funds that are plaguing their alternative investment portfolios.

Researcher Preqin estimates there are 1,200 private equity zombie funds — funds that are practically dead but still collect management fees — in investor portfolios worldwide with total unrealized assets of about $117 billion.

Until recently, these funds have been thought impossible to kill. Still holding some portfolio companies, they require a consensus of limited partners to end them. But investors are banding together with private equity firms that invest on the secondary market to create ways to send these zombie funds to the grave.

Some of the new end-of-life deals include buying out the holdings of investors that want out and creating a new fund, with the same holdings, for investors that want to let it ride.

Late last year, Chicago-based private equity firm Willis Stein & Partners restructured its third fund with capital from private equity firms Landmark Partners, Vision Capital LLP and Pinebridge Investments. That deal, which was brokered by secondary market intermediary Cogent Partners, allowed limited partners to either cash out or let their investment in the remaining portfolio companies live on in a new fund managed by Willis Stein and Vision Capital.

Behrman Capital, New York, did pretty much the same thing, creating a fund for the remains of a $750 million private equity fund it raised in 2000. Investors were given the option to cash out or continue investing in the new fund.

Dallas-based HM Capital Partners' zombie condition was rectified a different way. In May, two HM Capital executives — with the assistance of Landmark Partners — took $425 million in energy assets previously in the HM Capital Sector Performance Fund LP and launched a new firm, Tailwater Capital LLC, also based in Dallas.

HM Capital Sector Performance Fund LP was a buyout fund targeting companies in the energy, food and media sectors in North America, according to a 2007 investment report by Los Angeles City Employees' Retirement System, limited partner in the fund.

In March, other HM Capital executives formed a new firm, Kainos Capital LLC, with the food assets from the same HM Capital fund. The C$172.6 billion Canada Pension Plan Investment Board, Toronto, financed the acquisition for US$468 million. CPPIB also committed US$138 million to a new Kainos Capital fund.

HM Capital, which was the latest iteration of old-line private equity firm Hicks, Muse, Tate & Furst, no longer exists.

Zombie funds graphic

The $10.2 billion New Mexico Educational Retirement Fund, Santa Fe, sold off its interests in HM Capital Sector Performance Fund LP, said Bob Jacksha, chief investment officer of the $10.2 billion pension fund in an e-mailed response to questions. He declined to comment further except to say that as of Dec. 31, the investment showed a loss of -2.4%.

The $17 billion New Mexico State Investment Council also sold its interest, basically breaking even, said Charles Wollmann, spokesman for the council, also in Santa Fe.

Increasingly big deal

The zombie fund phenomenon is an increasingly big deal for investors, said Mario Giannini, CEO of alternative investment consulting and investment firm, Hamilton Lane, Bala Cynwyd, Pa.

“No one genuinely signed up for private equity to have a 10-plus-year fund with a big chunk of the portfolio still sitting there and a (general partner) charging fees with no real end in sight,” Mr. Giannini said.

“It is, unfortunately, difficult to find a solution for these funds. The real answer is to throw the GP out and get a competent one to replace them,” Mr. Giannini said. “The documents usually make that difficult and (limited partners) often are afraid of legal repercussions if they try to replace the GP.”

Some investors are ditching the funds on the secondary market. The $264.9 billion California Public Employees' Retirement System, Sacramento, is in the market to sell a $200 million basket of interests in venture capital zombie funds.

For some zombie funds, a secondary direct sale might make sense, said Mathieu Drean, managing partner and global head of secondaries at Triago, a Paris-based private equity fundraising and secondary markets firm. But it might be tough to get a decent price, he added.

Even so, there has been significant growth in the secondaries market, which could go part of the way in relieving investors of underperforming investments, said Nicholas Jelfs, London-based senior analyst and press officer at Preqin, in an e-mailed response to questions.

Close to one-third of limited partners surveyed by Preqin in March — 29% — said they sold interests on the secondary market in order to exit poor performing funds.

Boosting their efforts

A number of firms are boosting their efforts to find solutions to the zombie problem.

Industry Ventures LLC and Cogent Capital have been involved in some recent deals. Earlier this year, Hamilton Lane and Vanterra Capital helped fund the formation of NewGlobe Capital Partners LLP, a private equity firm focused on buying limited partnership interests in mature private equity funds and leading fund recapitalization deals.

Crestline Investors Inc., an alternative investment firm, and Kirchner Group, a merchant bank, both based in Fort Worth, Texas, in April launched a business unit called Crestline-Kirchner Private Equity Group to take over zombie funds and create value for investors.

Last July, consulting firm Kinetic Partners US LLP also announced it was getting into the business of helping to restructure zombie private equity and hedge funds.

These zombie fund restructurings are just starting, said Peter McGrath, president of Toronto-based Setter Capital Inc., an alternatives investment firm that invests on the secondary market. Setter executives estimate there are more than 1,400 private equity funds that have passed the end of their term or are approaching the end of their lifespan.

Some of the oldest funds still hold a significant amount of portfolio companies. In North America and Western Europe alone, Triago estimates there are more than 2,000 companies that remain in private equity funds from the 2000 to 2005 vintage years.

Restructuring the zombie funds is an attractive solution for general partners because when the new fund is created it restarts the clock on the portfolio company investments, Triago's Mr. Drean said.

“Suddenly the GP can make decent money out of a portfolio where there had been zero chance of making carried interest for them,” he said.

Robert S. Fore, partner, in the Menlo Park, Calif., office of law firm Goodwin Procter LLP said none of the solutions is cheap or easy.

Investors that choose to sell their interests on the secondary markets might have to take a deep discount. Plus, there are a myriad legal and accounting issues involved with restructuring a zombie fund, he said.

Sometimes, the hardest thing for both fund managers and investors is to acknowledge that the remaining investments are not good ones, Mr. Fore said.

“If it is a bad investment, the best minds in the world will not turn it into a gold mine,” Mr. Fore said. “Maybe everybody needs to accept it. It (the portfolio company) becomes an asset sale ... you need to move on.”

This article originally appeared in the June 10, 2013 print issue as, "End may be near for zombie funds".