The private equity industry should be feeling pretty good about itself right now. Total global assets under management stood at $3.2 trillion at the end of 2012 – a 4% increase from the prior year – and estimated global private equity buyout dry powder was $359.3 billion in October 2012, substantially down from the $488.4 billion pile at the end of 2008. But private equity – the entire industry grew by 136% between 2004 and 2007 – still has one legacy from the boom years to deal with. An estimated $75 billion worth of assets now sits in funds that have reached or are near the end of their contractual life and have no successor in place. Such end-of-life and disrupted cycle funds have been dubbed zombie finds and there could be as many as 200 of them that need to be dealt with.
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| Andrew Hawkins, CEO of NewGlobe Capital |
This problem will become more acute as the record volumes of funds raised before 2008 start to mature: such funds typically run for 10 years with two one-year extensions. So it is something that the industry needs to think about now. “There is no attractive option for GPs and LPs when funds expire and there is no successor fund,” explains Andrew Hawkins, chief executive officer of NewGlobe Capital, an independent secondaries investment firm focused on buying LP interests in mature private equity funds and recapitalization deals.
“Funds go into a period of gradual decline,” he explains. “In the past, LPs generally haven’t minded as the funds were either in carry or the amounts were small – maybe 2% to 3% of the original fund. But things changed dramatically after the collapse of Lehman in 2008.” The fallout from the private equity boom has been that in many cases managers have lost the confidence of their LPs. According to secondaries investor Coller Capital, 57% of LPs in North America have a stake in at least one zombie fund, with the equivalent number for Europe of 41% and Asia 50%.
“The boom years saw a large amount of capital deployed in overpriced and/or overlevered assets which led to significant LP disaffection in many instances,” Hawkins tells Euromoney. “Into that cauldron add the ingredients of LP overallocations and reduction in the number of GP relationships and you have a dangerous brew. There is a virtuous cycle in good years for private equity – funds get invested, investments are realized and capital is returned to LPs, and larger successor funds are raised. But once that cycle is broken it can get very ugly.”
It is just such an ugly situation that led to the recapitalization of middle-market private equity fund manager Willis Stein’s $1.8 billion third fund. The fund had reached the end of the 10-year life and was operating in the second of three available one-year extension periods. The restructuring, which involved a merger with a newly capitalized organization and the establishment of a liquidating vehicle and was arranged by Moelis, is one of Euromoney’s Deals of the Year for 2012.
“What we expected was that we would see a wave of opportunities in true end-of-life funds such as Willis Stein [which was in year 12],” says Hawkins. “But actually GPs with several years of runway left are coming to us when they realize that they may not be able to raise another fund in this market and therefore face an unattractive gradual decline.” New investors into Willis Stein included funds affiliated with Landmark Partners, PineBridge and Vision Capital – the latter a firm of which Hawkins is a former managing partner.
End-of-life funds that have performed well enough will be able to recapitalize without third-party involvement. For example, the winding down of Dallas-based HM Capital saw the management shed its media-focused investments to focus on food and consumer products via a new fund launched by new organization Kainos Capital. But for many zombie funds, new capital and new management will be needed to avoid a slow and lingering death. An economically rational GP will not want to sell assets as it cuts off its livelihood as the firm loses fees. They are therefore reluctant to put assets in a runoff vehicle where nobody is motivated to maximize value. The alternative is to abandon the fund and distribute assets to LPs – the last thing they want.
Partnering with a restructuring firm can therefore be a very attractive option for a GP. “They get a new life for the investments and a reset of incentives with the ability to rebuild a business,” says Hawkins. “Many of these portfolios have attractive assets but the companies have lacked capital and an energetic owner for several years. Restoring the motivation of the owner creates value by itself.”
This requires capital, something that NewGlobe has sourced via strategic partnerships with Hamilton Lane and Vanterra Capital. Vanterra Capital was involved in the establishment of Trilantic Capital Partners in 2009 which saw the transfer of $3.3 billion of assets from Lehman Brothers’ Merchant Banking funds III and IV into this new organization to be managed by former head of global merchant banking at the bankrupt firm, Charles Ayres.
The number of firms focused on recapitalizing zombie private equity firms where the LPs want out is so far small but should be set to grow. “There are people that could do this but it is a very new market,” says Hawkins. “Traditional LP secondaries players prefer diversified portfolios of flow names and are set up to be more passive. We have an active strategy as a hybrid LP/GP with the ability to influence the governance of the underlying companies – and not many firms' mandate will cover this.”
He emphasizes, however, that they are not turnaround guys. “We will not do a preponderance of loss-making businesses," he says. "We want revenue-generating businesses. So we wont do high tech, early stage or real estate. Otherwise as long as we can see a way of creating value we will do it. I am a cautious optimist – that is what you have to be in private equity.”
