Zombie Funds Impart Lessons on Alignment

While there are no easy solutions for GPs managing zombie funds, independent valuations keep interests aligned even as performance goes sideways.

By Frank Devine, Co-Founder and Executive Vice President, Murray Devine

The growing prevalence of zombie funds is challenging the conventional wisdom that deep value cannot be found through sponsor-to-sponsor transactions. In its 2018 Global Private Equity Report, Bain & Co. even cited the growth of zombie funds as one of the few pockets of opportunity in a rich pricing environment.

Bain defines a “zombie” today as a fund that raised capital between 2003 and 2008 and has been inactive for three years or longer. Underperformance is often the catalyst that sets these “zombie” scenarios in motion, although magnifying issues can include uncertain succession plans, mandate creep or anything else that may preclude future fundraising.

While these situations do indeed present opportunities for acquirers, they also create headaches for legacy managers and LPs. Moreover, regulators have begun to scrutinize zombie funds over perceived conflicts of interest, focusing on the extent to which monitoring fees and expenses replace and influence earlier performance-driven objectives. This underscores the role of independent valuations to ensure interests remain aligned even as traditional incentive structures break down.

A significant challenge facing GPs managing zombie funds (and one that characterizes any asset whose projected “sell by” date has lapsed) is that these companies often become increasingly difficult to value the further removed they are from the initial investment and any liquidity events. Many factors may have changed the original investment thesis altogether; most often “zombie” companies are beset by management turnover and lost market share. These factors only accentuate the negative feedback loop that further complicates and degrades valuations. Even more damaging are the funding constraints that impede top-line growth as investors are often hesitant to secure financing arrangements or restructurings that subordinate their existing positions or those of their co-investors.

The point, though, is that as both the backdrop changes and as corporate growth stalls, valuations should reflect all new considerations. This is particularly the case as assets grow longer in the tooth and investors begin to doubt whether mark-to-market estimates remain realistic.

Independent valuations can help zombie fund managers on three separate fronts. Perhaps most importantly, they provide the right cues to investors by demonstrating the GP’s commitment to the fund’s investors and thereby heading off any initial perceptions of self-dealing. Third-party valuations can help to ensure that stakeholders’ incentives remain aligned even as performance goes sideways.

Independent valuations also provide an important level of transparency, a recurring theme that has guided regulator efforts in the private equity space for some time. And few limited partners have ever complained about too much disclosure.

Finally, for both GPs and the management teams they back, robust and thorough valuations can reframe how value will be created going forward. This, of course, hearkens back to Peter Drucker’s famous quote that “you can’t manage what you can’t measure.”

To be sure, the private equity industry has shown remarkable growth over the past decade and has proven to be resilient in the face of considerable disruption. Flashback to 2008 when some well-regarded estimates called for an impending shakeout pegged to affect as many two of every five private equity firms.  Of course, with hindsight, these projections can seem somewhat absurd. The structure of private equity funds can make them extremely difficult to kill off but has also contributed to the number of zombie funds still operating today.

The bigger factor, though, is that the asset class has thrived by aligning the interests of entrepreneurs, general partners, and institutional investors to fund and drive sustainable long-term growth. Anything that can help foster this alignment, even when things go off track, is an investment that will pay off in the long run.

Frank Devine is the Executive Vice President and Co-founder of Murray Devine. He is a Chartered Financial Analyst and received a Bachelor of Science degree in Accounting from Villanova University.