Zombie fund restructurings are similar to coordinated liquidations of hedge fund side pockets, said Peter McGrath, president of Toronto-based Setter Capital Inc., an alternatives investment firm that invests on the secondary market.
In both cases, investors had been left with illiquid investments and little hope of cashing out. But hedge fund managers and investors in side pocket vehicles are ahead of zombie fund investors in finding ways to redeem their investments, industry insiders say. Zombie fund restructurings are just starting, borrowing some strategies from the hedge fund side pocket liquidation playbook.
Before the financial crisis, it was quite fashionable for hedge fund managers to opportunistically load up on illiquid investments, explained Simren Desai, vice president at Setter Capital. After the crisis, illiquid assets in everything from energy and infrastructure to real estate were dumped into the side pockets — separate, locked up investment vehicles with no set term.
Hedge fund firms “forced people to take side pocket instruments,” Mr. McGrath said.
Setter Capital estimates 200 managers have at least one side pocket fund, representing a total of more than $10 billion.
The glut of hedge fund side pockets is a one-time phenomenon that is expected to wind down in the next few years, Mr. McGrath said, whereas, the zombie fund problem is expected to persist.
To liquidate their side pocket holdings, investors are either selling off their interests directly into the secondary market or entering into a coordinated sale with the cooperation of the hedge fund manager, Mr. Desai said.
Direct sales involve an auction process of small pieces of the side pocket vehicle and little information about what is in the side pocket vehicle. As a result, sellers have to accept big discounts — typically ranging from 30% to 50% of the side pocket's net asset value depending on the quality of the underlying investments and the managers projected liquidity schedule, said Philip Leishman, Setter Capital associate.
In coordinated solutions, hedge fund managers extend tender offers to give investors a liquidity option. Investors are given the choice of staying on and rolling their investment into a new structure or selling, Mr. McGrath said.
These side pocket liquidations differ from the zombie fund solutions now in the private equity market, said Mathieu Drean, managing partner and global head of secondaries in the Paris office of Triago, a private equity fundraising and secondary markets firm.
Side pocket liquidations are driven by hedge fund managers that want to cash out, he said.
Before they sell, hedge fund managers not only analyze the sale price and returns but also where they will be reinvesting the cash, Mr. Drean said.
Meanwhile private equity managers prefer to bring in new capital and restructure the zombie fund, he said.
It is a different motivation and style, he said.
What's more, zombie fund restructurings appeal to a different set of investors, Mr. Desai explained. Opportunistic buyers are drawn to hedge fund side pockets, which are laden with high-risk, possibly high-reward assets.
“These buyers (of hedge fund side pockets) don't mind rolling up their sleeves and underwriting those assets,” he said.
More conservative buyers prefer private equity zombie funds because their portfolios are more coherent. They don't often have a huge, divergent variety of assets in them, Mr. Desai said.