How Maturing Secondary Transactions Took the Edge Off the ‘Zombie Apocalypse’

Provided by TresVista

The year 2015 saw widespread coverage in the private equity media of the potential problems of non-performing “zombie funds” – investment vehicles holding assets acquired before the 2008-10 downturn and unable to realize returns on those investments.

Concern was particularly acute that year because it marked the 7th anniversary of 2008-vintage funds. Reports indicated that as of July 2015, there were believed to be 1,180 zombie funds worldwide, all formed between 2003 and 2008 and holding more than 2,800 companies estimated to be worth $127 billion.

The concern back then was that a prevalence of underperforming zombies could drag down the private equity industry, threatening the fundraising capabilities of GPs and leaving LPs unable to rebalance their portfolios, with invested capital tied up on non-performing, “undead” funds.

Those 2008 funds were seen as culprits, having put money to work at peak valuations just prior to the financial crisis, only to see the value of their acquisitions plummet in the downturn.  Looking back, those concerns seemed largely unfounded. The private equity market has continued to boom, with robust valuations and 2015, 2016 and 2017 all standing as record fundraising years. These days, the challenge is to figure out which current-day investments are being made at the sort of top-of-market valuations that could make them part of the next wave of zombies.

It’s well documented that valuation multiples have been increasing over and beyond pre-crisis levels. And, a continuing increase in M&A activity will most likely put further pressure on multiples, as indicated below.


Three Trends that Have Taken the Bite Out of the Feared “Zombie Apocalypse”

One trend that has helped take some of the bite out of the feared “zombie apocalypse” has been the increasing prevalence of private equity secondary transactions as a liquidity option. These GP-led restructurings bring new capital into a fund and give LPs the option to sell or roll over their position at new, restructured economics.

Secondary transactions typically involve the direct sale of a fund’s entire remaining assets to a new investor, or a GP-led tender offer in which existing LPs are given the option to sell to a secondary investor, or stay in the fund, potentially under restructured terms or an extension of the fund life.

A third flavor of restructuring involves rolling over the entire fund into a new vehicle, with the same GP leadership and the backing of a secondary investor. Here too, LPs have the option to cash out or stay in.


GP Restructurings Take Center Stage

While discussed as far back as 2011, GP-led restructurings really began to pick up steam a few years later. Proliferation of GP-led transactions was a vital component to the secondary market’s growth, with an estimated $24 billion in transaction volume (up from $14 billion in 2017). While these transactions represented approximately 32% of total volume in 2018, they accounted for over 60% of the market’s year-over-year growth.


Secondary transactions can be tricky from many different perspectives, with the result that LP approval is by no means guaranteed. Among the potential issues:

  • The GP often is involved in both ends of a fund recapitalization and has both a fiduciary obligation to LPs to maximize value in an existing fund and a motivation to lower the price paid for those assets by the new vehicle
  • While many LPs will want to sell, transaction costs and any fee paid to financial advisors for their work on the restructuring can be a sensitive subject and something many LPs will want to negotiate;
  • Some existing investors may be happy with the existing fund and may not want to roll into a new vehicle or go through the restructuring of their interest.

As with nearly every aspect of the evolving private equity marketplace, GP communication and transparency about fees, interests and pricing are essential in securing LP approval of secondary transactions. Nearly all observers of the new wave of restructurings point to the need to secure an independent, third-party valuation of the assets being restructured, removing questions about mark-to-market valuations that are tied to an outdated investment thesis.

While secondary transactions remain a relatively new frontier in private equity, it seems logical to anticipate that the current surge in activity will result in the sort of stubbed toes and other misunderstandings that will generate best practices that govern how the industry handles the next generation of zombies – coming your way sometime in the 2020s!


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