private equity zombies–very hard to kill

what they are

The Wall Street Journal has been writing recently about private equity “zombie” funds.  These are funds that whose managers refuse to liquidate and return the proceeds to the original investors, even though the typical 8-10-year fund life has already passed.

A given private equity investment is supposed to last around five years.  That gives the managers time to make operating improvements and locate a buyer to sell the now-polished-up company to.  Add a year or so to that, so the managers to find enough good investments to use all the fund’s capital.  Add another, in case recession makes buyers temporarily wary.  That’s how you get to 8-10 years of life for the total fund.

In theory, private equity managers have no interest in keeping client money.  True, they get a recurring yearly management fee of around 1% of the assets under management (based, incidentally, on their own estimate of asset value–another bone of contention).  But their big payoff comes from their “carried interest,”  the 20% or so of the capital gains generated by each project that clients cede to them.  Private equity managers only collect this when the project is sold and proceeds returned to the clients.

The details, including the “sell by” date, are all spelled out in the private equity contracts.

How, then, can “zombies” arise?

The combination of two circumstances keeps them lurching around:

–failed investments, ones with no capital gains possibility, and

–clauses in the early private equity contracts that gave the managers (unlimited) extra time to find a buyer.  The intention was good–to not force the private equity managers to sell at a bad time.  In most cases, however, there was no other provision giving clients a course of action if they disagreed with the managers’ assessment.

The result is hundreds of failed private equity funds that refuse to liquidate, because managers want to continue collecting an annual fee.  They claim they’re looking for buyers, but…  The WSJ thinks that what we’re seeing now is just the tip of the iceberg.

two lessons

1.  Buy in haste, repent at leisure.  In the early days of any new investment fad, buyers rush headlong to be one of the first owners of the new thing.  They rarely look carefully.  If they are alerted about possible pitfalls, like no recourse if the private equity manager refuses to give back remaining money, they ignore the warnings.

2.  In desperate times, almost no one remains honest.  I’m an optimist.  I have great faith in human nature.  But in “zombie” circumstances, this is always a foolish bet.  At the very least, a professional with an obligation to protect clients’ assets shouldn’t rely on the kindness of strangers.

why not let sleeping dogs lie?

Institutional investors appear to be making a big push now to get their dud private equity investments resolved, even by selling them for half nothing (assuming they can find a buyer at all).

Why?

Two reasons:

–for taxable investors, an investment loss has an important tax value.  The present value of the loss deteriorates over time, so the sooner it’s used, the more it’s worth.

–keeping a dud investment on your balance sheet makes you look like an idiot.  Well, when you bought the thing, you were an idiot.  That’s the way it is.

But there’s invariably someone on your board of directors who will ask about it at every meeting.  Prospective clients may even make little gasping sounds if they recognize it on your list of holdings.  The black eye you’ve given yourself will only fully disappear when the investment is sold.  This is especially important if you see more of these coming down the track.

 

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