Half of LPs face zombie fund issues

The latest research from secondaries specialist Coller found that nearly half of the investors surveyed were exposed to these so-called “zombie funds” – where the GP has no prospect of generating carried interest but continues to oversee the fund in order to generate a management fee.

Only 6 percent of those LPs with “zombie” fund exposure thought they would be able to find a practical solution to the problem, while 72 percent said they would find a remedy in only a minority of cases. The issue appears to be particularly acute in the US, where 57 percent of LPs said they were grappling with it.

Stephen Ziff, a partner at Coller, said in an interview with PEI: “The findings on zombie funds show that in some cases the interests of LPs and GPs have slipped out of alignment. Many investors are asking, ‘How do you rectify that? How do you make a change?’ It’s not an easy decision for LPs, who are not used to collective action. Do they try to re-incentivise a failing manager or bring in another one who may not be as familiar with the assets? A secondaries investor can help, of course, but LPs still need to agree among themselves to take that approach.”

Coller’s Winter Barometer paints a gloomy picture of the asset class in Europe, at least in the short term: it found that the sovereign debt crisis has dissuaded as many as one in five investors from committing to European funds. Coller found 20 percent of the 107 LPs surveyed were likely to decrease their exposure to Europe as a result of the continent’s current woes.

Commenting on these findings, Ziff said: “We are in an environment facing a lot of challenges, against a backdrop of a looming sovereign debt crisis. Private equity, like many other asset classes, is being adversely affected by economic uncertainty. But in relation to those other asset classes, private equity is faring well.”

Jeremy Coller, chief investment officer at Coller, gave the survey results a positive gloss in a statement: “Some people might be surprised that private equity investors are optimistic about returns when they see so many challenges facing the industry. I think the explanation lies in another of the Barometer’s findings:  93 percent of LPs believe private equity investment results in healthier businesses. In investors’ eyes, the industry’s returns are underpinned by its ability to strengthen and add value to the companies in which it invests.”

Yet of particular concern to GPs will be the finding that LPs are reducing both the size and the number of commitments they plan to make. The survey found 93 percent of LPs will reject at least some of the re-up requests they are set to receive in the next 18 months. A “typical” (median) LP will refuse about a quarter of requests, Coller said. One in five expects to reject between half and all the requests they receive.

The majority of those LPs who do re-up will reduce the size of their commitments. With regard to the timing of commitments, 17 percent said they would never commit ahead of a first close, while only 22 percent said they expected to do so for most of their chosen funds.

All this shows that the pendulum has swung back decisively in favour of LPs, according to Ziff, who cited the finding that four-fifths of investors surveyed expected fund terms to continue to become more favourable.

GPs appear to be taking much longer to invest capital: 87 percent of LPs said they had received requests to extend investment periods, and four-fifths of respondents expected this trend to continue.

A majority of LPs (57 percent) felt that refinancing existing buyout debt would be a “significant risk” to the asset class. Ziff said concerns about debt would also affect allocations: “The areas of the industry where leverage plays the largest role will struggle – large buyouts especially.”

However, the longer-term prognosis was more favourable, he said. “Medium to long-term, the prospects for private equity look good. LPs see returns coming back. That’s a function of next year being viewed as a good vintage, and of LPs’ firmly held belief that private equity is good for businesses. Looking beyond the present, medium-term industry dynamics are pretty positive.”