How to defeat a zombie

John Wiencek provides a survival guide to managing undead buyout funds plaguing the LP community.

A ‘zombie fund’ is a near-dead private-equity fund that lingers on beyond its target life span, generally 10-12 years. Earlier this summer, we published a blog about these undead financial structures plaguing the investment community . Their impact is so pervasive we felt it worthwhile to take a deeper look at the issues and options in managing them for investors and GPs alike.  

Why so much investor angst over zombie funds? 

In short, because of locked-up capital. Of the roughly 10,000 private-equity funds raised over the past decade, at least 200 now qualify as zombie funds. As much as $100 billion of the $1.5 trillion currently invested in private equity is stuck in zombies, based on industry estimates. But here’s the scariest part of this particular horror story: the amount of assets in zombie funds could reach $500 billion over the next several years, according to the advisory firm Triago. Investors trapped in this nightmare situation are still paying management fees, typically 2 percent, well beyond the anticipated lifespan of the fund, despite the fund not being able to demonstrate a clear game plan on how it will deliver a return to investors. 

Managers are asking themselves: How can I keep my investors’ trust and satisfy them that I am doing all I can to wind down the fund in a manner that makes sense for everyone? How can I continue to service the portfolio and investors? What new reporting and regulatory requirements will I need to address? What can I do to control the expenses of continuing to run the fund?  And perhaps most importantly: How can I salvage the situation so I can raise a new fund?  

The scope of the problem 

More nightmare fodder: last June, a page-one article in the Wall Street Journal reported that the US Securities and Exchange Commission is looking into zombie funds as part of a broader probe of private-equity funds. The management fees private-equity groups charge investors in zombie funds vary, but often amount to millions of dollars.  A Forbes article, also in June, aptly sums up the zombie problem in the hedge fund space: “Four years after the onset of the financial crisis, tens of billions of dollars remain locked up in illiquid ‘zombie’ hedge funds that suspended their redemptions in the darkest days of the meltdown,” according to a recent DealBook article by Jay Eisenhofer and Matthew Morris. 

If the illiquid nature of these un-dead funds isn’t challenging enough, now increased scrutiny is an issue, too. Managers are damned if they do, and damned if they don’t. 

So what’s a manager to do?  

There are some textbook solutions we don’t necessarily recommend. Managers of zombies can opt to lower or waive their management fees beyond the lifespan extension period for the fund, but with such a tenuous market environment and the likelihood of increased traffic in the wind-down process from the anticipated additional zombies to come, this seems both impractical and financially imprudent.   

They can distribute the remaining assets if it can be arranged. But given the unmet investment targets of the fund, this option isn’t attractive, either. The LPs are stuck managing an assortment of private companies. They can throw in the towel, so to speak, and fire-sale the fund in the secondary market, assuming they can secure a buyer. Given the current environment, the discount is likely to be prohibitive–and will dissuade any manager intending to stay in business. The limited partners could attempt to stage a coup. They can try to overthrow the general partner by applying—through the court system—for a replacement agent to wind down the fund. But this is an arduous, lengthy process: finding a replacement with the requisite knowledge and expertise may not be fast or easy. David Fann, president and chief executive of TorreyCove Capital Partners, a private equity consulting firm, stated on that investors are loath to pursue many of these options. “The practical reality is that there are no good alternatives and it is hard for anyone to herd together multiple limited partners to take an adverse stance against a general partner of a fund,” he said. 

So the zombie lives on. What are the real options for a manager to maximise the windup of such a fund?  First, she has to reinforce investor faith in her intent and ability to finish the job, and still deliver relative performance, as held against other funds in like vintages that didn’t return any capital. Eek out a small return, and she might live to fight another day – especially if she zaps any investor suspicions that she’s just hanging around to collect fees.  

Valuation and sales process  

The heart of this exit plan is valuation of assets: both today and at exit. Zombie fund investments are difficult to price and sell, since one issue can easily compound another. Investors want to know if GPs are marking the investments too high. They want to know the time frame to liquidity. So it’s important to bring in third parties—valuation firms, investment banks, and third-party administrators – to independently value the assets, and set up a measureable process for marketing them to buyers. The case for an experienced administrator? He or she can focus on managing the collateral process from beginning to end, including valuation, documentation management, and accelerating getting cash back to investors wherever possible.  

Maintain service level to investors 

Anyone in the Zombie zone is, by definition, under greater operational pressure. Investors are likely being extra vigilant, especially when it comes to responsiveness, prompt reporting, and costs. Using a third party administrator may well yield cost savings – particularly if the administrator can introduce operational and technological efficiencies.  

Of course, the point isn’t to go cheap – particularly investor expectations are for service levels to stay on par (at least). If a fund’s staff senses the firm is in distress staff attrition will occur and attracting qualified replacements will be more difficult, making maintaining the service level even more challenging. Third-party administration can also minimise the workforce drain. 

Partnering with one that also provides flexible, tailored, and comprehensive fund  administration services is one of the strongest outreach strategies a manager can employ to optimise the needs of both investors and operational upkeep. Meanwhile, management personnel are liberated, and can focus on the portfolio – how to clean up any problems at companies and get them sold. 

Address new challenges 

The most critical advantage of bringing in third-party expertise is the ability to keep abreast of the latest in regulatory and industry changes impacting zombie fund managers and investors alike. With the increased legal focus, pent-up frustration of locked-in investors, and a growing army of these walking-dead funds looming on the investment horizon, there’s no better time for managers of these funds to add skills to their forces.  

John Wiencek is a managing director at AltResources, a fund administration provider for private equity firms.