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Zombie Fund Glut Bad For LPs, Good For Bargain Shoppers

More than $116 billion is tied up in funds well past their "sell-by" date, new data shows. That may be bad news for their investors, but experts say it's good news for bargain hunters in the secondary market.

According to industry tracker Preqin Ltd., some 1,200 funds are beyond their intended life spans, holding stakes in more than 1,700 companies with little hope of an exit. Their sponsors have not raised follow-on funds, and have returned just 40 percent of capital back to investors, Preqin found.

These funds are clinging to life, stuck with assets that are hard to price and even harder to sell. Management fees dwindle, investor patience thins, and with no new deals coming in, staff members jump ship. These vehicles quickly find themselves sporting one of the financial world's least flattering labels: zombie funds.

"The amount of capital in funds that are past their investment period has grown tremendously," said Michael Wolitzer, a partner with Simpson Thacher & Bartlett LLP. "You can see the inventory increasing dramatically."

Some managers genuinely see upside in their portfolios, Wolitzer said. Some are just dragging their feet. But all have the incentive to do nothing except sit tight and collect management fees.

"There's this idea for the private equity sponsor of, 'If I could get another few years to work on the portfolio,' Wolitzer said. "But if the sponsor is unlikely to get carried interest, there isn't a lot of incentive to sell or work hard to create more value."

The zombie glut has opened the door for a small group of white-knight specialists offering new cash and an exit plan. At least four such restructurings have closed over the past year, and industry sources say several large ones are in the works.

The basic idea is this: A new backer comes in and offers limited partners a choice to either cash out or roll over their stakes. The general partner swallows a steep discount, but picks up a small stake in any upside. Some get extra capital to try to reinvigorate their firms.

Last summer, Chicago-based private equity firm Willis Stein & Partners restructured its third fund with help from Vision Capital LLP, Landmark Partners and Pinebridge Secondary Partners. The fund, 12 years old and underwater, was stuck holding three companies and had already run through two extensions.

New York's Behrman Capital did roughly the same thing in September, partnering with Vision Capital to form a $1 billion, six-year vehicle for what was left of its 2000 vintage fund.

HM Capital, a zombie fund from the Hicks Muse Tate & Furst sponsor line, found a different fix. Two directors spun off the firm's energy assets last month into a new fund, called Tailweather Capital, with equity from Landmark. Another management group did the same thing with food assets, aided by $450 million from Canada's biggest pension fund.

Each of the four deals has looked a little different.

Willis Stein went with a merger, an unusual choice because funds are basically empty boxes for the assets they hold and aren't really built to merge. But it guaranteed Vision the kind of control it wanted. Hicks Muse and Behrman opted for spinoffs. Tender offers have been kicked around, too, though nobody has used one yet.

"The market has not defined how these transactions look yet," said Michael Belsley, a Kirkland & Ellis LLP partner who worked on the Willis Stein and Hicks Muse deals. "There's no model, but with each one, we start to get a sense of what works in what circumstances."

These deals are tricky, Belsley said. The portfolios are hard to value, and balancing the interests of all three groups — the general partner, the limited partners and the white knight — requires a delicate touch. Nobody likes the status quo, but crafting a deal everybody will sign on to is tough.

Enough limited partners need to cash out to make the deal worth the new investor's time, but not so many that it becomes too expensive. The general partner should take enough of a haircut to assure limited partners it's not getting a sweetheart deal, but not so much that bitter executives spend the next four years grumbling.

Plus, partnership dynamics vary widely from fund to fund. Some funds empower a limited partners advisory board to negotiate, some don't. Some require a simple majority of support to amend their agreements, some two-thirds or even three-quarters. Some limited partners will want to see a fairness opinion before they'll talk price. The Willis Stein restructuring, for example, involved two separate amendments to the decade-old limited partnership agreement and 600 pages of disclosure documents.

And that's even before getting to the commercial questions, which loom large, Belsley said. Secondary investors are buying an asset pool that's largely trapped, with some possible diamonds mixed in with the duds. Most will try to pick and choose; Willis Stein spun off some assets Vision didn't want, and HM split itself up by industry.

Secondary investors "need a strong stomach," said David Fann, CEO of TorreyCove Capital Partners LLC, an alternative assets consulting group. "You have to really dig into the portfolio companies and separate the good companies from the bad ones."

So far, it's a small group of investors doing the digging. Out in front are London-based Vision, which just closed a €680 million ($907 million) fund and expanded in New York, and Landmark, a trans-Atlantic firm that buys private equity and real estate portfolios. Morgan Stanley's alternative investment unit and the Canada Pension Plan Investment Board are active, too. And experts expect more traditional secondary buyers like Coller Capital Inc. and HarbourVest Partners LLC to poke around.

Fann said he expected the number of players and the pool of available investment capital to grow. He compared secondary buyouts of zombie funds to distressed investing 20 years ago, growing from a niche product to dedicated asset class.

"A lot of GPs are running out of runway," Fann said. Secondary buyouts "recognize that there might still be some upside, while cashing out investors who might be tired."

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