Annual private equity fund raising escalated at an astounding pace from 2004 through 2008, increasing from $46 billion in 2004 to $186 billion in 2007 and $132 billion in 2008. This trend, like the world markets, collapsed with the onset of the Great Recession. Post credit crisis, funds’ were unable to sell their portfolio companies or raise new funds. Today, the landscape is awash with orphan funds—funds at, or near, their contractual end-of-life that continue to hold illiquid investments. While the current IPO, M&A, and financing markets are robust, many of the investments in orphan funds are not good IPO or sale candidates, typically due to a need for additional support capital for the investments or additional time needed to achieve representative results.
In many cases, the interests of GPs and LPs in orphan funds are no longer aligned when the former have been unable to raise a new fund and are unlikely to earn a carry on the remaining fund assets. LPs disdain paying ongoing, non-performance-based management fees. The size of the problem is large—last year, Preqin estimated that there were over 1,000 orphan funds. Fortunately, a variety of alternatives like fund recapitalizations and fund M&A have developed for orphaned assets, or the funds themselves, allowing them to find new homes.
A fund can be recapitalized via a sale of all of its assets to a new fund, and allowing existing investors to roll over their interests into the new fund or receive their pro rata share of a cash distribution. This happened when Willis Stein & Partners restructured its third fund in the face of investor redemptions. The two lead investors underwrote/backstopped the new fund together with a fresh new money commitment and then offered existing LPs the choice of cash for their LP interests or letting the LPs rollover their interests into a newly formed vehicle, which had new GP economics. Additional sponsors who have completed or launched fund recapitalizations include funds sponsored by JW Childs, Aurora Resurgence, The Endowment Fund, Perseus, Veronis Suhler, Ironbridge, and First Atlantic.
While similar to fund restructuring, fund M&A involves the outright sale of the fund’s assets. GPs looking at asset dispositions are faced with the decision of whether to sell the assets in bulk or on a piecemeal basis. The unknown is whether they will get incremental value for less desirable assets via a total liquidation. Ziff Brothers recently announced their intention to undertake a $1.2 billion bulk sale of six portfolio companies. One Equity’s separation from JPMorgan is another such example.
Fund recapitalizations and fund M&A have numerous advantages over individual asset sales. First, the uncertainty surrounding the original fund can finally be resolved. Second, there is a large and growing pool of specialized buyers for these types of assets. Competition among numerous bidders typically drives an optimized sales price. Third, harder-to-sell assets are typically easier to sell if bundled with the perceived “good” assets.
Additional techniques such as take-privates (in total or in part), LP buybacks, and leverage at the fund level are starting to emerge.
Best Practices for a Successful Deal
Houlihan Lokey’s transaction opinion practice has provided fairness and valuation opinions for many orphan fund transactions and have identified the following best practices for a successful deal. First, it is important to start with an accurate assessment of fund asset values before launching a process (which typically takes six months to complete). We have seen transactions fail despite reasonable offers for fund assets due to inflated reported net asset values (NAV) at the time of the transaction. Sponsors and their agents have a vested interest in ensuring that LPs’ expectations are appropriately and accurately managed. Second, if the fund has a functioning and involved Limited Partner Advisory Committee (LPAC), the fund should engage the LPAC early to walk through the alternatives and brief them on a proposed strategy. Key execution considerations and investor sensitivities can be uncovered early, and subsequent surprises can be minimized. Third, the prospective lead investors can be expected to do substantial due diligence, frequently hiring consultants and financial advisors to prepare quality of earnings reports. Sponsors and their agents should consider obtaining objective, independent quality of earnings reports in advance, and making them available through the transaction data room for all prospective lead investors, not just those who have gone exclusive. Finally, a significant percentage of fund recaps have had LPAC requirements (or external counsel advice) for obtaining a fairness opinion prior to seeking an LP election given the conflict involved when a sponsor is selling assets from a legacy fund to a new fund managed by the same sponsor.
While the Great Recession created a material dislocation in the private equity asset class, effectively creating a substantial number of orphan funds, the marketplace remains resilient with a new class of solutions and investors arising to facilitate the recycling of otherwise stranded private assets. With a properly structured process, the market is poised to grow and create more win-win outcomes out of otherwise losing situations.
Authors Tad Flynn, Kreg Jackson, and Terence Tchen are all managing directors with Houlihan Lokey.