Lps and Zombie Funds in Private Equity Investment
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LPs and Zombie Funds in Private Equity Investment This report was prepared by Stefano Migliorini (MBA Class, July 2014) in the first half of 2014 under the supervision of Claudia Zeisberger, Academic Director of the Global Private Equity Initiative (GPEI) and Professor of Decision Sciences and Entrepreneurship and Family Enterprises at INSEAD, and Michael Prahl, Executive Director of the GPEI. The data presented was extracted from Preqin. We wish to thank them for their engagement with GPEI and support on this project. GPEI welcomes private equity investors interested in the centre’s research efforts to reach out to us in Europe or Singapore. For further information on INSEAD’s Global Private Equity Initiative, please visit www.insead.edu/gpei. Introduction and Overview 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.1 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,2 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. We 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. We 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 our findings we have included several case studies highlighting specific points and recommendations. We 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 our findings will help improve the efficiency of the capital allocated to this asset class. 1 As an example, both Permira and Apax reduced fund size by about 50% and fell short of their fundraising goals. 2 Notable exceptions include Candover and Duke Street. PRIMER: PE Fundraising and Fund Incentive Structure To understand the zombie fund issue, we begin by describing the fundraising challenge faced by the PE industry following the global financial crisis, as well as the incentive structure of a typical private equity fund. Post-Crisis Fundraising Falls Before the GFC, the PE industry experienced what has been dubbed ‘the golden age of PE’, with fund-raising and deal-making reaching record highs. Between 2003 and 2008, annual PE fund-raising grew at a CAGR of 46%, reaching a combined $2.5 trillion for the five year period ending 2008. The boom saw a sharp rise in average fund size as well as in the number of GPs that raised funds (more than 1,100 GPs in both 2007 and 2008). As the chart shows, the GFC had a significant negative impact on PE fund-raising, both in terms of the amount of funds raised and the number of PE firms raising a fund. While fund-raising has picked up significantly from its lowest point, the number of GPs raising a fund has stagnated, reflecting LPs unwillingness to back smaller and first-time funds, preferring to direct their allocations to established GPs. The fallout from the GFC was felt differently across the regions. Funds raised by European and North American buyout firms fell most steeply, reflecting the negative headwinds facing these economies in the wake of the crisis. While the GFC was not the undoing of the PE industry, as some commentators had foretold,3 the sharp fall in fund-raising resulted in a large number of PE firms unable to raise a follow-on fund. As a result, the number of zombie funds rose dramatically. 3 For example, BCG’s (2008) Get Ready for the Private-Equity Shakeout never materialized. PE Fund Incentive Structure To see how potential conflicts of interests arise between LPs and GPs in the case of a zombie fund, it is important to understand the incentive structure of a PE firm. There are four main sources of revenue: Management fees: Management fees, the primary source of income for GPs, cover all the expenses incurred by the PE firm including salaries, day-to-day operating costs, and the cost of monitoring portfolio companies. They typically range from 1.3% and 2.5%, and are assessed on a different basis at different stages in the fund’s lifecycle, according to: o committed capital during the investment period, typically 3 to 6 years following a fund’s first close, and o the lower of i) invested capital, and ii) the fair value of the existing portfolio following the expiry of the investment period. Carried interest: Carried interest represents a ‘performance’ fee, usually equal to 20% of the capital gains realized from a fund’s investments. Carried interest is payable to the GP after a hurdle rate or preferred return is realized by the fund’s LPs, typically 8%. If the hurdle rate is not reached, no carried interest will accrue to the GP. Carried interest can be assessed on a deal-by-deal basis (an American-style waterfall), or on the overall fund favored by LPs (a European-style waterfall), as all capital committed to a fund must be returned before a GP is entitled to carried interest. Deal fees: Each time a GP completes an acquisition or an exit, it may charge a deal fee, typically between 0.5% and 1.5% of the deal’s equity or the enterprise value. Charging deal fees was common practice until a few years ago, when LPs started to exert more pressure on GPs to improve their fee structure. Management fee offsets, a mechanism now typically employed via limited partner agreements, minimize the impact and subsequently the frequency of deal fees. Monitoring Fees: Once an investment is made, many GPs charge a monitoring fee, paid by the portfolio company, for consulting and advisory services, which accrues directly to the GP or an affiliated entity. The object of the service will depend on the specific situation. Fees are typically charged every year for the duration of the investment. As with deal fees, management fee offsets can significantly reduce the impact on LPs net realized fund performance. Focus on Zombie Funds Post the financial crisis and the global economic downturn, performance in the private equity industry fell sharply, evidenced by a reduction in the median internal rate of return (IRR) for global buyout funds from 19.5% to 10.5%.4 The GFC’s impact on lower performing funds was no less dramatic – the median IRR for third quartile buyout funds fell from 10.5% to 6%. As a result of poor performance and a decreased appetite for investing in PE funds following the crisis, the number of managers who failed to raise a follow-on fund increased. The graph below details the prevalence of zombie funds as of year-end 2013. Each annual data pair reflects the number of funds and amount of capital by managers who have not raised a new fund from the date indicated. For example, the “2008 or before” dataset indicates that 379 funds with commitments of $217 billion dollars are by firms unable to raise a follow-on fund. AMOUNT RAISED BY GENERAL PARTNERS BEFORE A SPECIFIC DATE $bn/# of funds $400bn 379 $350bn $300bn $250bn 223 $217bn $200bn $150bn 108 $95bn $100bn 56 $50bn 19 $35bn $3bn $11bn $0bn 2004 or before 2005 or before 2006 or before 2007 or before 2008 or before Last Fund raised # of Zombie Funds # of Zombie Fund GP The “2008 or before” dataset assumes a PE fund becomes a zombie fund after a five year period during which the PE firm did not raise a follow-on fund. This is broadly in line with the 4-5 year investment period of most PE funds and the follow-on fund-raising that typically occurs (or is at least underway) towards the 4 Performance reflects global buyout funds from pre-crisis vintages (2001-2004) and post-crisis vintages (2005- 2008). Source: Preqin. end of that period.5 According to this dataset, there are currently 379 ‘zombies’ managing funds with committed capital of $217 billion. If we take a more conservative approach and assume that PE firms can delay fund-raising by another year without major economic consequences, then we count 223 zombies managing funds with committed capital of $95 billion, as reflected by the “2007 or before” data set in the graph.