Zombie funds: Fright of the living dead

The problem of assets "stuck" in a GP's portfolio is a growing one. Essentially, as the funds surpass their life span, they are in a stalemate through three different obstacles: LPs receive no rollover cash and liquidity; GPs cannot raise new capital; while the companies are offered no new money and attention. These so-called zombies are fast climbing to the top of LPs' agendas, because, as long as zombies lurk in the shadows of the private equity world, investors' money is tied up in them and can't be put to use elsewhere.

"The key problem with zombie funds is that you are unlikely to have somebody that is actively managing your assets anymore," says Francesco di Valmarana from Pantheon. "The worst scenario is when you have a portfolio of impaired companies and it doesn't look like the GP is going to get carry out of that fund, then the GP is managing that portfolio for its management fee. They are actually incentivised to milk that portfolio for its management fee for as long as they can." In other words, it constitutes a clear case of misalignment of interests between LPs, GPs and the management of a company.

The growing divergence between the top 2% of fund managers (those that are able to raise capital quickly) and the bottom quartile is a contributing factor to the spread of zombie funds.

LPs are increasingly spooked, while GPs are adamant there is still hope

More recently, direct secondaries firms that buy zombie portfolios including Vision Capital, Verdane Capital and Cipio Partners are becoming a mainstay in the wider private equity landscape. Vision, which closed its seventh fund on €680m, is looking to buy mature portfolios of mid-market European companies, while Munich-based Cipio focuses on smaller venture capital investments in the direct secondaries segment. This niche market within the secondary arena is a risky approach, because, whereas secondary funds buy up stakes, direct secondaries players buy entire portfolios of operating companies. The approach takes some time as it requires the co-operation of the vendor firm. The buyer can then either manage the investments themselves or employ a new fund manager.

Dave Lamb, head of the European deal team at Vision, views the issue in a more positive light: "I'd like the concept to be shifted away from viewing these as GP failures. Of course there are instances where GPs can't raise a new fund because of a poor track record, but these are not the most interesting situations."

He argues that in some instances GPs are choosing not to embark on traditional fundraisings because the risk is higher and there are other ways to fund deals. In other cases, a GP's ability to fundraise may be subject to factors beyond their control, such as the original founders of a firm moving on and creating a generational change in the fund, or due to a number of the existing LPs moving away from the asset class.

Booming hangovers
Says Lamb: "What we are seeing is a swathe of funds raised in the boom times reaching the end of their investment period, coupled with a much tougher fundraising climate. This is affecting good and bad managers alike. The solution will be providing liquidity to the LPs coupled with new time horizons and fresh capital to the underlying companies." Lamb argues that it provides an opportunity to create value in high-quality assets that are constrained in their current ownership structure.

HarbourVest partner Peter Wilson has a similar viewpoint: "The most important feature to the zombie fund dilemma is that it can create a winning dynamic: investors seeking liquidity today on one hand, and hopefully, on the other hand, good assets that need a few years to mature.

"As buyers, we can have a wider time frame to liquidity compared to LPs, many of whom run out of time or patience... We can help those funds' limited partners finally see a return on their investment. The likelihood is we will see more of potential 'zombie' fund investment opportunities in the future."

Pantheon's di Valmarana does not believe zombie funds will constitute a large number of closed transactions in the secondary market, however much deal flow there might be. This is because LPs that know the value of the portfolio companies do not relish the idea of selling at a 50% discount to an already written-down portfolio. According to di Valmarana, sometimes the best thing is that a secondary player comes in and injects new capital, but LPs should ensure they have explored every alternative before that happens.

The limited partnership agreement may provide the possibility of a no-fault divorce, but there are also a few other routes available for concerned LPs. One option is to get younger members of the existing management team back on track and push a fruitful exit. "We believe in very active portfolio management and in looking out for any signs that the interest of the GP is flagging. The way to do this is to stay very close to GPs, talking to them, and engaging with the portfolio company managers. If you can catch things early, it's possible to turn a potentially severely underperforming portfolio into a moderately successful one," says di Valmarana. Other alternatives could be to replace the manager of the fund or the LP structure.

It remains to be seen to what extent LPs themselves can turn things around, and how much of a positive impact direct secondary investing will have on zombie funds as an exit alternative for distressed investors. Eventually, it will come down to how the assets were acquired in the first place. Still, zombie funds are a worry that is likely to cause LPs more sleepless nights in the future.

The next issue of unquote", available November 11, in the Apple newsstand and in the November print edition, will look further at this issue, examining the underlying motivational issues faced in such circumstances.

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