December 2015 Issue
Though a true zombie apocalypse is unlikely, zombies of a different sort have disturbed the sleep of private equity (PE) professionals in recent years. Indeed, ‘zombie’ private equity funds are becoming a genuine concern for the wider PE market. Zombie funds present firms and the PE industry with a variety of challenges, the most striking of which relates to a lack of resources to execute the fund’s mandate, and the imprisoning of much needed capital in non-performing funds. Furthermore, zombie funds can create a significant disconnect between the interests of GPs and LPs, creating a misalignment the net result of which will see LPs unable to realise their investments and GPs suffering reputational damage.
Typically zombies – firms which retain their investments for longer than their scheduled holding period – underperform compared with other funds and threaten the fundraising capabilities of other PE groups. The reputational damage borne by GPs can have a detrimental effect on further fundraising efforts; by the same token, LPs are unable to rebalance their portfolios.
As at the end of July 2015, there were believed to be around 1180 zombie funds, originally formed between 2003 and 2008, globally, sitting on unrealised assets worth $127bn, according to data from Preqin. These zombie funds are also holding 2821 companies. Worryingly for firms in the PE space, the number of zombie firms seems to be on the increase, and the value of unrealised assets held in these funds is climbing. In 2013 there were 999 zombie funds worldwide with unrealised assets of $80.9bn; in 2014 the number of ‘living dead’ funds reached 1049. India has become something of a hotbed for zombie funds in recent years, though funds focused on North America account for 45 percent of the worldwide total. European focused funds made up 29 percent of those studied, while Asia accounted for 12 percent.
“The value of unrealised assets held in these funds is climbing.”
“We have witnessed an increase in the number of zombie funds within the private equity industry over recent years,” says Preqin’s head of private equity products Chris Elvin. “Our latest analysis now includes funds with a 2008 vintage, for which many would have been making investments at the peak before the financial crisis hit. As such, these funds are likely to have found it difficult to realise assets for a profit, resulting in an estimated 250 funds becoming zombies.” 2008’s zombie funds have an overabundance of unrealised investments, with assets worth $42.2bn yet to be exited. Funds from between 2006 and 2008 have unrealised assets worth $100bn between them.
“Zombie funds are a point of contention within the private equity market,” adds Mr Elvin. “If they are struggling to sell the assets in their portfolio for a profit, firms can sometimes find themselves extending the life-cycle of a fund far beyond what they originally intended. As they continue to take management fees on the assets they hold, managers can come under increased pressure from investors to liquidate the fund.”
One of the primary drivers behind the increase in both zombie fund numbers and assets is the inclusion in this year’s data of 2008 vintage funds, many of which invested capital just before the onset of the financial crisis in an attempt to capitalise on peak prices during that period. However, once the crisis took hold these funds plummeted, never to recover. Venture capital funds in particular account for the highest proportion of zombie funds. Over half of all zombie funds are currently venture capital funds. The fact that the sheer number of zombie funds reported by Preqin still exists today is a concern, particularly when one considers that we have enjoyed a number of years of bull markets.
According to Preqin’s data, those zombie funds formed in 2004 had a median distribution of 37.4 percent, against the industry average of 94.4 percent. When considered alongside those funds launched close to the financial crisis, the 2004 vintage appears impressive. Those zombie funds launched in 2007 have paid out just 21.6 percent to date. Worryingly for investors, while these funds have performed woefully in terms of distributions, they have still been subsisting on their management fees. The average zombie fund charged investors the industry-typical 2 percent annual management fee, according to Preqin.
On the surface, this number of zombie funds in the private equity industry, and the number and value of the assets they hold, appears to be a considerable negative. However, for agile firms there are still good deals to be made. As with all transactions, the key is to look in the right place, and this remains true for today’s private equity market. Firms must be wary, however. Just because a deal appears to be solid on the surface does not necessarily make it a good deal. As with all zombies, firms must ensure they don’t get bitten.
© Financier Worldwide
BY
Richard Summerfield