Watch out for the zombies

Concern is increasing about struggling funds that will cling to life for as long as possible to keep collecting fees. LPs must get together to kill them off, writes Christopher Witkowsky.

The threat is real: private equity managers who are not likely to raise future funds may simply be stringing out the life of their existing fund in order to continue raking in management fees – so-called ‘zombie’ funds. Unsurprisingly, this has led to more limited partners banding together to present a united front when negotiating with these GPs.

Indeed, this kind of unified LP action is likely to happen more often as an increasing number of GPs fail to generate enough support for future funds in today’s stingy fundraising environment.

Inter-LP cooperation was highlighted recently when a GP offered its limited partners a shift in the structure of the fund’s management fee to one based solely on the cost of operating the business in exchange for an extension of the fund’s life.

The fund’s LPs had banded together last year to try to extract some concessions in exchange for the extension. This didn’t achieve immediate results, but this year they got the budget-justified management fee. One LP involved in the talks says the firm’s partners will not collect any more management fees.

Over the past few years, LPs have done a lot of work improving their bargaining position with GPs. The focus on LP/GP dynamics is important and has led to many improvements in the industry, including those triggered by the voluntary principals set out by trade group Institutional Limited Partners Association. The fund is not likely to generate a huge return for LPs, the source said, but at least investors will only pay a fee linked to the running of the business.

It’s a situation that fits in with the nature of private equity partnerships: “GPs die a slow death, and they’ll bleed as long as you let them.”

GPs who are not able to raise a follow-on fund present a risky scenario to LPs – they may be slowly losing their investment professionals if the fund is underperforming and not likely to pay them carry; the heads of the fund may be simply managing out the remaining assets while still benefitting from lucrative fee payments.

In this situation, LPs should work together to determine whether they would benefit more from the GP managing out the assets, or from simply closing the fund down. If the latter route is pursued, it’s worth bearing in mind that the LP advisory council may not have the interests of all LPs in mind, outside of the biggest investors. Also, the advisory council may not be able to meet without the GP also being present. This may force LPs into more informal communications.

“There’s a number of GPs out there who have realised that the writing is on the wall and that they’re not going to raise another fund. The tools you have to counteract [a GP who has lost motivation] are a telephone and an LP list and talking to other LPs,” one industry LP said during a conference in New York earlier this week.

However, LPs arguably now need to concentrate a little harder on their relationships with fellow fund investors. The LP/LP relationship is evolving as investors find themselves in situations where they have to exert pressure on their managers to do the right thing.

LPs that have not traditionally communicated well with their peers may now have no other choice. Those who present a united front will always likely find ways to ease the passing of a damaged fund.