Fundraising Frenzy: Mass zombification unlikely, but alarm bells are ringing

The term ‘zombie fund’ has popped up frequently in the pages of Private Equity International and its peers.

In August 2015, affiliate title Secondaries Investor reported that there were more than 1,000 zombies: funds over 10 years old, with assets remaining in their portfolios, managed by GPs who hadn’t raised a subsequent fund.

Many of these were investing in the lead-up to the global financial crisis, buying assets at the top of the market just as the rug was swept from under their feet. As of August 2018, 2008-vintage funds held more unrealised NAV – around $220 billion – than those from any other year going back to 1999, PEI reported, citing data from Coller Capital.

With public markets dropping precipitously and competition for LP capital more intense than ever, is another episode of mass zombification on the cards? How many GPs have the skills and experience to navigate their portfolio companies to a timely, profitable exit in a market where valuations are dropping?

“Private equity managers will have to generate returns predominantly from top- and bottom-line growth, rather than multiple arbitrage,” noted Vincent Gombault, former head of Ardian‘s fund of funds business, adding that around half of the returns generated in private equity over the past decade have come from an increase in the price of assets.

There are some similarities with the GFC. In 2021, US and European companies acquired by private equity sponsors were bought for an average enterprise value to EBITDA multiple of 12x, the highest level since 2004, according to LCDcomps. The average net debt to EBITDA multiple was 5.8x – second only to 2007, when it hit 6.1x.

Like in 2009, many managers are struggling to raise capital – not just unproven or poor-performing firms. One New York funds partner said his firm was making provisions for longer fundraising periods in the limited partnership agreements of several clients coming to market. For LPs, doors that were long closed are now opening.

“Some GPs that have always been a bit sniffy are now reaching out,” said a European managing director with a fund of funds. “Normally they call up an LP and say, ‘Yes, you may kiss the ring, you may invest in our funds’… There’s been a subtle shift – not a big one – in the balance of power.”

Different ballgame

There are also some key differences with the GFC. PE funds raised $433 billion in 2008, the peak of six consecutive years of growth, PEI reported. This fell to $327.6 billion in 2009 as panicked LPs pulled money from the asset class.

There is no suggestion that an exodus is on the cards today; many LPs remember that down markets bring opportunities as well as challenges. Many are considering using the secondaries market to free up capital for reinvestment, though mismatched pricing expectations are stopping deals getting done for now.

“We are seeing LPs increase their allocations – in a lot of cases, truly increasing their exposure [rather than for portfolio rebalancing purposes],” said the co-head of private funds at an investment bank, describing current events as a “long-tail slowdown”.

While levels of zombification are unlikely to spike, there will be victims, as the ongoing flight of capital to the largest and most specialised firms continues. Mid-level and junior employees could become restless and start to look for pastures new, at which point it will become clear who has a long-term plan and who doesn’t.

“A lot of people [in PE] don’t run very good businesses,” the head of a large multi-asset alternatives manager told PEI earlier this year. “Their firm is a tool for individual wealth creation, and they haven’t put the same thought into their own business and strategy that they put into [that of] their portfolio companies.”

He continued, ominously: “There have been events of natural selection in private markets in the past. This is a market that demands something different, something special to draw attention and draw allocation – that’s life.”