Zombies are lurking within general partners’ debt portfolios – zombie investments that is.
When a credit fund reaches its final moments, managers and investors expect the vehicle’s loan portfolio to mature and fade away with it. Most funds wind down that way, but sometimes managers reach the end of a vehicle’s life with more work to do and must devise a plan for the lingering loans.
With funds being formed for up to a decade or even longer, a lot can change in the economy and credit markets, having unforeseen impacts on the portfolio. And there can still be investments to work out after the customary fund-life extensions expire.
“It is the case for many credit funds that you can actually align that nicely,” Ropes & Gray partner and private credit funds practice leader Jessica O’Mary said regarding loan maturation and termination of a fund. “On the other hand, there are a lot of credit funds that have other types of assets or residual interests that may not align with the end of the fund.”
The factors that can prevent a loan from reaching its maturation on time vary in size and impact. The issues can be problems within an individual portfolio company, industry-specific factors such as regulations or tariffs, or macroeconomic situations like a recession.
“You can end up with what you thought were plain, vanilla loans that are now a much more complicated distressed asset,” said Ira Kustin, a partner in the investment management practice at Paul Hastings. “You can have portfolio investments toward the end of the life of the fund that are not exactly clear regarding when you will be able to realise those opportunities.”
When faced with a zombie investment, the next step isn’t always clear, as these loans usually represent bespoke situations where there isn’t a one-size-fits-all solution, Kustin noted. He added that the specific loan terms and the size and scale of investors and investments also complicate the process.
“Some [investors] may be interested in getting some money back faster, while other investors are willing to extend and wait much longer in order to get more money back,” Kustin said. “Obviously, with a broad investor base, investors are not necessarily going to have interests that are aligned.”
The easiest solution for managers that are operating multiple fund strategies at a time could be to extend the loan’s terms and roll it into a different fund that operates a similar strategy such as via a continuation fund. This would allow investors to transfer their investments to the new vehicle, but some of those investors may also want liquidity.
There are many other options for these leftover loans, including enlisting third-party help for an asset sale or liquidation.
If enough investors want to liquidate their positions, the firm can sell the remaining loans as a bulk asset. This is usually easier than selling off assets individually, said Morri Weinberg, a partner and co-head of the private funds group at Ropes & Gray. But if opinions are mixed, investors can also sometimes make the decision to sell or liquidate on their own, depending on the path the manager takes.
“I think it’s definitely a growing issue,” Kustin said. “It’s also something that is being addressed proactively in new funds that are being launched or marketed now. Investors will basically sign on to terms recognising that there is some potential for some more complicated investments when the term expires.”
However, it’s hard to plan for the hypothetical.
O’Mary and Weinberg said that they haven’t seen the firms they work with successfully putting end-of-life transaction provisions with great detail into the terms at the fund formation level, despite it frequently being discussed. That is probably because it’s hard to plan for a bespoke situation that could be 10 years down the line, Weinberg noted. O’Mary added that it is also much easier to present each opportunity to investors separately with actual evidence to help outline the best possible solution.
“At least then you have concrete backing,” Weinberg said. “So you can say, ‘This is why we think this transaction make sense,’ and have a conversation at that point to move forward.”
As the credit cycle continues to churn, more zombies will continue to rise, and conversations around how to send them back to the grave will follow.