Investors face longer lockup periods as fund life spans rise

Private equity funds are living longer, with assets under management in tail-end funds to balloon as a result of the pandemic and current recession.

Tail-end funds are ones still active 10 years after their initial closing. Global assets under management held in tail-end funds grew to $324 billion, up 13.5 times in the 10 years ended Dec. 31, 2018, according to a recent study by BRG Asset Management LLC, a subadviser and replacement asset manager for challenged or tail-end investments.

Some 44% of funds raised before 2009 are still active. It currently takes until year 15 on average for 95% of funds to fully liquidate, said Finbarr T. O'Connor, New York-based managing director and head of BRG's alternative investment advisory practice.

Total AUM in tail-end funds was only $21 billion, excluding dry powder, in 2007 at a time when global private equity AUM was $974 billion, the study shows.

Assets in tail-end funds are set to grow as a result of the COVID-19 crisis due to slowing portfolio company exits combined with maturing funds, Mr. O'Connor said. "It's really a fact of life that funds exist past 10 years," Mr. O'Connor said. "This cycle, more funds will take more time to fully liquidate," just as they did in 2008, because in recessionary times it is harder to get liquidity, he added.

Limited partnership agreements typically give the general partner two automatic one-year extensions. After the automatic extension periods are over, the GP then has to ask limited partners for extensions. Management fees are typically paid during the entire time, albeit sometimes at a lower rate than the fund's investment period."There is a cost burden to managing mature funds beyond a certain point," Mr. O'Connor said. "When a fund gets below a certain threshold of AUM, the fixed nature of certain administrative and management costs becomes a disproportionate slice of investors' return as the fund gets longer in the tooth."

And there are always going to be tail-end funds in the making. "We routinely see a reluctance by managers to deal with problem assets, that in and of itself is why certain funds get stuck, and particularly if a manger is underwater, hanging on to the hope that he can recover," Mr. O'Connor said.

The assets in tail-end funds can grow quickly following a recessionary period. Between 2007 and 2010, tail-end fund assets increased by 581% to $122 billion, the BRG study showed. Total global private equity AUM grew only 36% to $1.3 trillion during the same period. After the Great Recession, mature assets grew staler due to the illiquidity and uncertainty, the study said.

Even so, it is different this time, the study noted. The tail-end fund AUM is larger than it was in 2008, and the pandemic has already affected a far broader geographic and sector asset base, the study said.

Tail-end fund AUM will grow more in this recession because of the volume of capital already scheduled to mature post-COVID-19 due to the record levels of fundraising prior to the pandemic-induced recession, Mr. O'Connor said. Private equity funds worldwide raised more than $500 billion a year through 2019 when private equity raised $595 billion, according to Preqin.

"There are managers that have year eight or nine funds that are going to have to find exits, either in the public or private markets, but now most likely at lower valuations," he said. "Their dilemma is: Do they transact at a lower valuation level in the near-term markets or wait for a better day, which could be a couple of years out?"

Given the large increases in capital raised since 2013, it follows that there will be more tail-end funds over the next few years, Mr. O'Connor said. In fact, BRG executives are tracking some funds in their late cycle, in years eight and nine, beginning to exhibit tail-end fund characteristics, he added.

The effect of the COVID-19-led recession is also expected to slow tail-end fund distributions to investors, the BRG study said. In the last recession, tail-end fund distributions declined by 50% in 2008. Since 2016, tail-end funds have distributed about $200 billion each year, the study showed. Despite these record distributions, even more in value remained undistributed at the end of each year. For example, in 2018, $204 billion was distributed compared with $324 billion in unrealized value, the study showed.

How private equity funds fare in this environment will depend on the economy and where the fund is in its investment cycle, said Gavin Farrell, director at BRG in New York.

"If you're managing a private equity fund in harvest mode and looking to return capital to investors over the next three years, you're facing some big headwinds to produce returns," Mr. Farrell said. "That's not to say the fund will be an underperformer, but you are likely going to have to reset investor expectations about the timing and value of asset realizations."

On the flip side, funds raised in the past two or three years that are in their prime investment period will have "lots of great companies in need of investment," he said.

The challenge for private equity limited partners is that the secondary market has hit pause for the past four or five months because nobody can do due diligence, and everyone is waiting to see where second-quarter valuations land, Mr. Farrell said.

Secondary market advisory firm Greenhill & Co. Inc. reported that alternative investment secondary market transaction volume was $18 billion in the first half of 2020, a 57% drop from the first half of 2019.

In the meantime, managers that invest on the private equity secondary market are raising capital to take advantage of what they expect to be discounted buying opportunities, Mr. Farrell said. Secondary buyers are estimated to have $180 billion to deploy, the BRG study said.

But transactions have slowed. Greenhill said there was an aggregate 800-basis-point decline in the average high bid across all funds and strategies in the first half of 2020 compared with the year-earlier period.

"It will be interesting to observe the pricing and the type of deals that get done" on the secondary market, Mr. Farrell said. "Right now, both LPs and managers alike are in a real tough spot and similar to other parts of economy, those with time and liquidity on their side will survive and prosper; those without are likely to suffer."

Investors can also fairly easily determine whether the general partner has the staff and incentive to properly manage out the tail-end assets, BRG's Mr. O'Connor said. For example, if a manager no longer expects to receive carried interest, "what kind of incentive is there to manage appropriately, especially if there are shiny new toys to manage in his or her subsequent fund?"