A previous blog post discussed the existence of zombie funds in the private equity industry as well as their effect on the investor market. Approximately $116 billion is sitting in almost 1,200 zombie funds and their presence is an impediment to the growth of investor wealth while continuing to accrue management fees for ineffective managers. ((Clare Hutchison, More Than $100 Billion Trapped in ‘Zombie Funds:’ Industry Data, Reuters (June 13, 2013, 1:00 PM), http://www.reuters.com/article/2013/06/13/us-zombiefunds-data-idUSBRE95C0XJ20130613.)) Government agencies have taken steps to minimize the reach and influence of such funds, but they are not alone. The private sector has also been responding actively to help investors with their illiquid assets.
The formation and expansion of such private business strategies are responses to market demands for alternative solutions to leaving capital in zombie funds. ((See Michael Wursthorn, Crestline Forms New Business to Combat Zombie Funds, Private Equity and Venture Capital, Dow Jones (April 30, 2013), http://pevc.dowjones.com/Article?an=DJFLBO0020130430e94unh0pi&cid=32135011&ctype=ts&pid=15&ReturnUrl=http%3a%2f%2fpevc.dowjones.com%2fArticle%3fan%3dDJFLBO0020130430e94unh0pi%26cid%3d32135011%26ctype%3dts%26pid%3d15.)) Financial companies have risen to the occasion by raising large amounts of capital that will be dedicated to lifting underperforming private equity funds out of “zombie status.” For instance, earlier this year, Crestline Investors, a hedge fund firm, launched a new business line to focus on acquiring zombie fund assets. ((Id.)). It partnered with merchant bank, Kirchner Group, to form Crestline-Kirchner Private Equity Group, which will acquire, manage, and invest in underperforming assets of private equity funds (i.e. the focus will be to tackle zombie funds). ((Id.))
NewGlobe Capital is another newly formed company expected to spend over $1 billion over the next two to three years on end-of-life and disrupted cycle private equity funds. ((Id.)). It defines “end of life funds” as those that have reached the end of their 10-year life cycles and 2 year extensions with a substantial portfolio of assets remaining unsold. ((Jonathan Shieber, NewGlobe Capital Launches to Rid Private Equity of ‘Zombie Funds,’ Wall St. J.: Private Equity Beat (Jan. 24, 2013, 12:12 PM), http://blogs.wsj.com/privateequity/2013/01/24/newglobe-capital-launches-to-rid-private-equity-of-zombie-funds/.)). “Disrupted cycle funds” are those that have had trouble raising additional capital and are looking to recapitalize and give money back to their investors. ((Id.)) The strategy is to offer investors an exit option from their current zombie investments with either cash buyouts or an opportunity to roll their cash into a new investment vehicle. ((Id.))
Crestline-Kirchner Private Equity Group and NewGlobe Capital are both using fund capitalizations and secondary sales as business strategies. ((Wursthorn, supra note 2; Shieber, supra note 5.)) Fund recapitalization works well when the target fund has reached the end of its investment period but still requires extra capital to support its portfolio companies. The injection of additional capital helps the funds create further value for the investors. ((Alec Macfarlane, Investors Seek Ways of Dealing With ‘Zombies,’ Fin. News, (July 16, 2013), http://www.efinancialnews.com/story/2013-07-16/investors-seek-ways-of-dealing-with-zombies?ea9c8a2de0ee111045601ab04d673622.)) When an investor injects more capital, it gets a “preferred equity” position where it stands to receive a return on their investment before other investors. ((Id.)) This strategy is effective in cases where the fund has value that has not yet been realized. ((See Id.))The difficulty with this strategy is that recapitalizations are complex transactions that involve many different stakeholders. Since the various parties have their own goals and motivations, it is difficult to find common ground on which to proceed. ((Id.))
A secondary sale takes place when investors sell their fund stake to other investors. ((Id.)) The value that they recover is significantly less than the net asset value of the assets (typical recovery rates are 50% – 60%) but it is an escape from a difficult investment. ((See Id.)) Other options are “secondary direct transactions,” where the fund manager sells an entire portfolio, or “hybrid secondary transactions,” where an investor commits to a new fund and receives a stake in an old fund as part of the agreement. ((Id.)) The difficulty with secondary sales is the same with that of fund recapitalization – that investors have different agendas and may have different opinions on which investment strategies to undertake. ((Id.))
Another possible approach is “resetting the carry.” Under this strategy, the goal is to change the economics of the fund so that the manager receives a portion of future profits earned by the fund (as opposed to most fund requirements that the manager earn a threshold return before being entitled to proportional reward). ((Id.)) It allows carried interest to be paid at an earlier than usual stage to ensure that managers remain incentivized to improve the value of the portfolio. ((Id.)) The criticism of this approach is that there is no reason to reward managers who are not helping their investors. ((Id.))
One other way for investors to deal with zombie funds is to change the management team. ((Id.)) They can take control of the fund through a standard “no fault divorce clause,” which allows investors to remove a manager and appoint a new manager with a majority vote. ((Id.)) However, this is troublesome and costly and for some investors, the benefits do not justify the costs of exercising this option. ((See Id.))
The growth of the secondary market for zombie funds has been strong but there are many risks involved for both the firms and new investors. Target fund portfolios are difficult to value and balancing the interests of all parties presents a significant challenge. ((Liz Hoffman, Zombie Fund Glut Bad For LPs, Good for Bargain Shoppers, Law360, (June 14, 2013, 8:47 PM), http://www.law360.com/articles/449869/zombie-fund-glut-bad-for-lps-good-for-bargain-shoppers.)) It is also a fine art to ensure that an efficient number of limited partners are cashing out while not making the deal too expensive. ((Id.)) The various voting structures in place in different funds also puts a twist on how new investors should approach different deals. ((Id.)) Though the benefits can be great, secondary market investors need to have an appetite for risk and be careful about which funds to invest in. ((See Id.))
Though zombie funds typically have negative implications for their original investors, the emergence and development of the secondary market has provided exit options to dissatisfied investors as well as new investment opportunities for new investors. Firms have been utilizing different methods of trying to revitalize zombie funds and each new strategy is giving them a better idea of what works. ((Id.)) As time progresses, it is likely that the market will continue to gain knowledge and experience of how best to deal with zombie funds.
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