Senior Affiliate Professor of Entrepreneurship and Family Enterprise
Report | October 2014
Through the last cycle following the global financial crisis (GFC), stagnant economic growth in mature economies, greater economic and political uncertainty, increased sovereign risks, and a reduction in the amount of available bank financing led to a significant reduction in the performance of the private equity (PE) industry overall.In response to lower performance and higher uncertainty, many investors (limited partners or LPs) reduced their allocations to PE funds raised by fund sponsors (general partners or GPs). As a result, a number of well-known PE firms had to delay fund-raising or reduce their fund-raising targets. The difficult fund-raising environment extended to the mid and lower mid-market, where a number of firms struggled and failed to raise follow-on funds. While for the most part this occurred out of the public eye, it did not go unnoticed by the LP community. In June 2013, Preqin estimated that there were about 1,200 “zombie funds”– PE funds managed by sponsors unable to raise a follow-on fund – which had some $116 billion under management. Zombie funds present a range of issues, chief among them a lack of resources to execute the fund’s mandate, misalignment of interests between GPs and LPs, and capital trapped in non-performing funds. The aim of this report is to explain how LPs approach zombie funds in their portfolios and how GPs are managing the situation. It draws on insights from interviews with LPs and service providers such as lawyers and placement agents. The authors start by describing what constitutes a zombie fund and the typical PE incentive structure that can lead to conflicts of interest between GPs and LPs. The authors then address the zombie fund issue in more detail, delving into (1) the magnitude of the problem in LP portfolios, (2) the nature of the problem (why LPs decide not to reinvest in certain GPs), (3) how LPs are addressing the problem, and (4) steps that GPs can take to increase their chances of successfully raising a follow-on fund. To illustrate these findings the authors have included several case studies highlighting specific points and recommendations. The authors hope that our comprehensive overview of this under-studied but topical issue in the private equity industry will be of use to both LPs and GPs facing issues resulting from zombie funds, and that their findings will help improve the efficiency of the capital allocated to this asset class.