Secondaries Special: Finding a cure for zombies

In the early 2000s, Willis Stein & Company was at the forefront of the private equity industry. The firm raised one of the biggest investment vehicles in the business, collecting $1.8 billion for its 2001 third fund.

However, the firm took big losses when the tech bubble burst in the early part of the decade, and its $840 million second fund, a 1998 vintage, suffered accordingly.  One of its biggest setbacks came when Ziff Davis Holdings, a New York-based publisher of technology magazines that was one of Willis Stein’s major portfolio companies, filed for bankruptcy in 2008 – wiping out the firm’s equity.  And all this was happening just as the firm was raising and then starting to invest its third fund.

Fund III is now the subject of a restructuring on the secondary market that is intended to give limited partners a number of options. They can either cash out of their entire holding in Fund III at 90 cents on the dollar – equivalent to a net asset value of about $280 million. Alternatively, they can choose to roll some or all of their economic interest into a new vehicle being formed to house the three companies still in the fund’s portfolio – which the firm has decided to hold onto in the hope of finding a more opportune time to exit.

The deal has received widespread attention in the industry because it’s seen as a creative way to restructure a fund that has gone on well beyond its intended life span. That’s an issue that many industry players expect to be dealing with for a long time as the plethora of funds raised over the last decade come to the contractual end of their lives – and some of them are hanging on for dear life.

Justin Pollock, a managing director at secondary firm Newbury Partners, says the number of tail-end funds on the market is rising steadily. “Some of these funds continue on for years. You wind up in year 12 and LPs start to ask questions,” he says.

The number of funds raised in the past 10 years is very large, and at least some of them will need to be restructured. That’s partly because – particularly with underperforming funds – there will probably be “discontent” among LPs, according to Jason Gull, partner with fund of funds and secondaries shop Adams Street Partners. “Partnerships are fragile creations,” he points out.

THE CLEAN-UP JOB
At the end of 2011, the Coller Capital Barometer, an annual survey of investor sentiment in the industry, revealed that about half of LP respondents believed they had zombie funds in their portfolios. Coller defined zombie funds as those run by managers with no prospect of carried interest trying to keep funds alive in order to keep collecting management fees.

Not surprisingly, tail-end funds that have been extended beyond their original terms have become more common on the secondary market, as “LPs have increasingly utilised the secondary market to sell these older vintage funds”, according to Cogent Partners’ half-year secondary pricing report.

The increase of tail-end funds on the secondary market is because many LPs these days are trying to cut down the size of their portfolios, in order to reduce their number of manager relationships.

“Funds are staying around a lot longer and LPs want to clean things up, they want to be done,” says Todd Miller, partner at Cogent Partners. “You talk to any LP, one of the most annoying things they get are extension requests from GPs.”

In the first half of 2012, funds that were 2000-vintage or earlier comprised 26 percent of the funds Cogent marketed, the firm said in the report. These funds had an average high bid of 76 percent of net asset value during the period, Cogent added.

Typically, such ‘clean-up’ sales have been executed by fund of funds or smaller institutional investors, though more recently public pensions, sovereign wealth funds and corporate pensions have been offering deals that include a large number of non-core, lower quality funds, Cogent said.

The biggest constraint on the volume of deals like this will always be the limited universe of potential buyers for these assets. However, according to the report, sellers are at least starting to adjust their expectations to a more realistic level. “It is worth noting that many sellers and their boards or investment committees are increasingly able to rationalise and support sales of underperforming funds of non-core managers, often at meaningful discounts to net asset value,” the report said.

GETTING SOME HELP
In restructuring its third fund, Willis Stein is getting help from secondary firms Landmark Partners and Vision Capital. Both are part of an investor group that is contributing $220 million to buy out LP interests and form a new vehicle to house the three remaining portfolio companies – the for-profit Education Corporation of America, telecoms company Velocitel and recycling business Strategic Materials.

The transaction will also be financed with more than $40 million from LPs rolling over their interests into the new fund, plus $25 million from additional equity or debt financing (or further LP rollover).

Willis Stein executives will control the newly formed fund alongside Vision Capital, according to sources with knowledge of the deal – and the firm will continue to collect a management fee, sources add.

Initially, up to $30 million of LP rollover would have been on a carried interest-free basis, but that was expanded to exclude carry on all LP rollover, sources said.

All three firms declined to comment on the deal.

Another relatively well-publicised fund restructuring is that of Behrman Capital’s $1.2 billion third fund. In this case, a ‘non-traditional’ buyer, the Canada Pension Plan Investment Board, is anchoring a transaction that will create a new fund to house some remaining Behrman assets, according to several secondary market sources with knowledge of the arrangement, who added that Cogent Partners was brokering the deal.

It’s certainly true that not everyone is happy with restructurings like these. One Willis Stein LP expressed frustration with the long life of Fund III and felt the deal was another way to keep paying a management fee to the GP. Others have expressed frustration that Willis Stein partners could still walk away with carried interest from the last three portfolio companies (depending on the returns they generate) – which in their eyes would equate to pay without performance.
But funds that live on past their intended lives generally inspire strong emotions from LPs – ranging from the slightly annoyed to the passionately angry, depending on how the funds perform.

Another LP, unconnected to the Willis Stein situation, said end of life fund situations have become extremely tedious to fund investors who feel they have abided by the terms of the limited partner agreement, only for the GP to come back and ask to change the terms. The situation is, inevitably, even worse when the fund in question is not likely to produce a return for LPs.

“GPs die a slow death, and they’ll bleed as long as you let them,” one market source told PEI.

This type of restructuring is particularly common in the venture capital world. Many funds that were raised during the tech investing bubble were bludgeoned when the economy slumped in the early part of the 2000s and have been unable to fully exit investments.

However, not every fund in an extended-life situation is a terrible performer; in many cases, it’s simply that the exit environment of the past few years has not allowed firms to find the kind of value they feel their companies deserve, and so they choose to hold their companies instead of cashing out.

In fact, in some cases, it may actually be an issue related to team turnover that leads to a slow winding down of a firm.
For example, StepStone Group last year helped close out a fund that had lived beyond its contractual life. The Monte Brem-led firm financed the creation of a venture fund to house legacy assets from computer networking pioneer Ray Noorda’s investment firm, The Canopy Group. Canopy had been in the process of winding down since Noorda’s death in 2006.

Using capital from separate accounts from its clients, including sovereign wealth funds, pensions and endowments, StepStone backed the creation of Signal Peak Ventures to manage the Canopy portfolio, which included equity and debt interests in 10 companies. Two managing directors from Canopy, Ron Heinz and Brandon Tidwell, were selected to lead the new business.

A GROWING PROBLEM
The expectation among industry professionals is that zombie funds are not going away anytime soon. Indeed, the problem (at least for LPs) is likely to grow as more and more managers try to raise capital, fail, and eventually come to the realisation that they have no future.

Advisory firms are springing up to help LPs deal with these types of situations. But sources on the secondary market also expect more creative transactions to help put zombies to rest for good.

It will remain a balancing act. LPs who have paid management fees and haven’t seen much return from funds will probably be reluctant to hand over what they see as more fees or economics to GPs with whom they are not happy.

However, if the overall goal is to close out some of these legacy funds, secondary players who are willing to dive into contentious situations may be best positioned to find solutions for these zombie problems.