Private Equity Trapped In 'Zombie Funds'

13 December, 2011

About half of all institutional private equity investors have a stake in a “zombie fund” where unsuccessful managers with no hope of getting a bonus are holding on to the investments as long as possible to live off the management fee, a global survey shows.

The findings are yet another strong sign of difficult times for private equity as many groups struggle to cope with the fallout from the credit-fuelled takeover binge in the run-up to the financial crisis.

The situation is most prevalent in North America, where 57 per cent of the investors said they had capital locked in an underperforming fund, according to the Global Private Equity Barometer, due to be published on Monday by Coller Capital.

Private equity funds are typically structured with a 1.5 to 2 per cent management fee and “carried interest” that pays managers a 20 per cent share of the profits.

There is usually an 8 per cent profit threshold that managers have to achieve before they get paid a performance bonus.

“Some groups that really pushed things in the good times will now pay the price by not achieving the hurdle rate necessary for carried interest [the performance bonus],” said Jeremy Coller, founder of Coller Capital, one of the largest global investors with interests in second-hand private equity.

If a fund is lossmaking and managers have no realistic chance of achieving the hurdle rate, they stand to gain from holding on to investments as long as possible as the management fee is based on the size of the portfolio.

This is bad for investors whose returns are diluted by the longer holding periods as they have to pay management fees over a longer period of time, Mr Coller said.

In the survey of 107 global institutional investors, 94 per cent said they would find no solution for a majority or even all of the “zombie funds”.

“When there is a really sharp correction like the one we have seen in recent years, investor and manager interests can slip out of alignment,” Mr Coller said.

Some private equity managers counter that investors could push for changes. “As an investor in private equity, you can directly engage with the GP [the buy-out management company], while at a public company all you can do is shout at the annual meeting,” Mark Florman, chief executive of BVCA, the British private equity lobby organisation said.

Four-fifths of the investors surveyed expected to receive further requests in the next few years to extend the investment periods of private equity funds, in a sign of how buy-out firms are struggling to spend the large mountain of capital that they raised during the boom years of 2005 to 2008.

The investment period is the time in which a private equity fund spends the committed capital on acquisitions of companies, which typically runs for five years.

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Private Equity Trapped In 'Zombie Funds'

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