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Zombie funds reborn on growing secondary market

Restructuring gives GPs, LPs options with underperforming funds

Frank Morgan
Frank Morgan said many 2006 funds are ripe for restructuring.

Restructuring private equity funds that are close to, or have reached, the end of their fund lives is a growing business for firms that invest on the secondary market — a business that could double by the end of this year, industry insiders say.

Restructurings breathe new life into so-called zombie funds, allowing managers to turn around an underperforming fund and possibly raise a new one later. Secondary managers see these restructurings as an expanding source of transactions.

For limited partners, it is a way to get out of these funds — which are nearly dead but still collecting fees — albeit many times it means getting out at a discount. Limited partners that stay are taking a bet — in effect doubling down — that the general partner that has so far disappointed them can turn around the portfolio and produce a return.

Many secondary private equity managers and brokers expect the value of restructurings to double this year. In the first half of this year, 30% of private equity secondary market transactions were generally partner-led deals, mostly restructurings, according to Dallas-based secondary market broker Greenhill Cogent LP. GP-led transactions amounted to $3.6 billion in the six months ended June 30, compared with $2 billion in all of 2013, the first year for which Greenhill Cogent has data.

In a fund restructuring, secondary investors invest new capital to cash out existing limited partners of a fund reaching the end of its life.

In some cases, the private equity manager will seek to extend the fund and alter the terms, such as the management fees or carried interest hurdle rate, the minimum return the firm must earn before the manager can collect carried interest, said Paul Verbesey, Washington-based partner in law firm Goodwin Procter LLP.

David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC, said his firm's clients are faced with a restructuring decision “almost every week now.”

Secondary private equity managers anticipate the increase despite more scrutiny of restructurings by the Securities and Exchange Commission and limited partners.

“We are seeing a lot more of the restructurings,” said Frank Morgan, partner and president of Coller Capital-U.S., who is based in New York. “There were a lot of funds raised in 2006 to 2007 just before the global financial crisis and those are bumping into their 10-year fund lives. It's not surprising the numbers (of restructurings) are coming up.”

Coller expects its restructuring business to double from last year. Mr. Morgan estimates Coller Capital invested about $3 billion to restructure private equity funds over the past 14 months.

In one of the firm's largest such transactions, Coller led the $1 billion restructuring last year of $2.7 billion Irving Place Capital Partners III, a 2006 vintage private equity fund, Mr. Morgan said.

Investors in the Irving Place fund include the $188.7 billion California State Teachers' Retirement System, West Sacramento; $48.5 billion Pennsylvania Public School Employees' Retirement System, Harrisburg; and Oregon Investment Council, Tigard, which oversees the $68 billion Oregon Public Employees Retirement Fund, Salem. Officials at all three funds declined to comment on their investment or how the restructuring affected their portfolio.

Coller also helped restructure private equity firm J.C. Flowers & Co.'s 2006 buyout fund, the $7 billion J.C. Flowers II.

The Oregon Investment Council is also an investor in J.C. Flowers II. Other investors in the fund include the $101.8 billion New York State Teachers' Retirement System and the $43.5 billion Teachers' Retirement System of the State of Illinois, Springfield.

Calls to those funds were not returned by deadline.

Unrealized value

Helping to create the increase in restructurings is the large amount of unrealized value that still remains in older private equity funds, said Laurence G. Allen, managing member and CEO of secondary market brokerage NYPPEX, Rye Brook, N.Y., in an e-mail. In the first half of this year, NYPPEX estimates the amount of unrealized value in older private equity funds increased 6% from the first half of 2015.

Unrealized assets in buyout and growth funds of vintages 2006 or older totaled $214.4 billion as of Dec. 31, the most recent figure available, according to London-based alternative investment research firm Preqin.

“Being long in the tooth isn't such a good thing in private equity,” said TorreyCove's Mr. Fann. “Generally, anything that solves a zombie fund, and gives the LPs a choice to stay, or go, is a good thing,” he added.

However, SEC officials have expressed concern about some of these restructurings, according to transcripts of speeches given last year by two high-ranking SEC officials. And the agency's attitude hasn't changed.

“We still consider this area a compliance risk for private equity as the market for restructurings grows,” said Igor Rozenblit, New York-based senior specialized examiner and co-head of the  Private Funds Unit, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, in a written statement to Pensions & Investments.

Mr. Fann explained the SEC questions “whether true fair market value is being paid to exiting LPs, especially when the (general partner ) is getting a new life in the restructuring. In some cases, the LP providing capital to the restructuring gets better economics, or inducements to participate” — so-called stapled secondary transactions.

Restructurings allow secondary funds to put billions of dollars of capital to work, said Justin Kaplan, an alternative asset analyst who helps manage the 4% alternative investment allocation of the Horsham, Pa.-based life insurance company Penn Mutual Asset Management LLC.

Penn Mutual has a $13 billion general account. The life insurance company has about $200 million allocated to buyouts, including uncalled capital commitments.

Struggle to exit

Restructurings are becoming more and more prevalent as private equity firms struggle to exit their portfolio company investments, Mr. Kaplan said.

While none of the private equity funds in which Penn Mutual invests is being restructured, Mr. Kaplan said the insurer has been approached to be a new investor in a restructuring.

“We think it (that approach) is interesting,” because investors are not taking on the blind pool risk of a private equity fund investment, Mr. Kaplan said.

Sometimes, managers that are in trouble because of poor returns forgo a restructuring and just close a fund, giving investors private shares in the portfolio companies, he said.

While this is not typical, the idea of getting private shares of companies that the investor then has to liquidate when the GP could not, is not an attractive option and could push some investors to accept a less-than-attractive restructuring deal, he said.

“What is clear is that a fund restructuring is quite negative for the liquidity of the fund,” said Kishore Kansal, managing partner of London-based secondary market broker PEFOX LLP.

This might seem counterintuitive because a restructuring would seem to be “the perfect time” for dissatisfied investors to sell, Mr. Kansal said.

“The problem is that you find there is only one buyer in this case — the buyer that is willing to back the team going forward,” he said.

Other potential buyers are put off because of the uncertainty of the fund's future and complexity of restructuring transactions, he said.

“Thus, whereas before the fund restructuring you might have been able to sell your LP stake at an attractive price to a large pension fund, once there is even a sniff of restructuring, all of those buyers disappear and all you are left with is an experienced secondary fund who will be willing to buy your interest at a significantly lower price,” Mr. Kansal said.

“Worse still, once a fund restructuring has taken place, the GP then has an extremely close relationship with one particular secondary buyer, and will point any sellers after this in the direction of that buyer,” he said.

But NYPPEX officials don't agree that limited partners get raw deals when they sell their limited partnership interests in a restructuring.

“In the (first half of ) 2016, LPs that accepted secondary bids from fund restructuring deals often received very attractive prices,” NYPPEX's Mr. Allen said in an e-mail. n

This article originally appeared in the August 22, 2016 print issue as, "Zombie funds reborn on growing secondary market".