Zombie Funds: How the SEC is Arming Itself Against the Undead

Private equity funds can produce good returns, but some inevitably will not. And some, too, will become illiquid. Enter the zombie fund, a private equity fund (or hedge or venture-capital fund) that contains hard-to-value illiquid investments that have gone bad and lingered beyond the funds’ targeted lifespan. Zombie funds often have stale valuations that foster the reporting of much higher values than current fair-value measurement would produce.

Preqin data, reported in June 2013, indicated there were 1,200 zombie funds with $116 billion of assets in funds that had reached the end of their expected holding period and had no successor fund planned. And the original value of the investments tied up was far greater than that. The number of zombie funds is likely to rise over the next several years, as older funds with non-performing assets reach the end of their original expected holding periods.

The greater prevalence of these funds can threaten private equity standing with both regulators and LPs alike.

Where are the zombie funds?

Zombie funds are typically older and at the end of their expected holding periods. They should be put to rest, but the higher stale valuation of fund assets and attached investor agreements keep these ill funds alive. Because of the assets’ illiquidity and the investment terms, investors are locked into these funds, which continue to accrue management fees without a strong likelihood of a future payoff. If the assets in question were immediately sold, then the market would likely pay a lower value than the value being reported, and the funds, as well as their investors, would recognize significant losses.

Consider this example: A private equity fund with an expected term of 10 years made a $500 million investment in several Internet-related start-up companies in 2000. The start-up ventures, along with several other investments the fund held, proved disappointing. Reporting states that the investment in these companies is now worth $100 million, but this figure is based on a valuation analysis of the businesses that was performed internally two years ago. It turns out that the real fair value measurement exit price is likely less than $1 million. Even though the fund is nearly dead, the higher valuation being reported and the terms of the original agreement means that investors will pay higher fees for a longer period of time than should be warranted.

Investors complain that the unrealistically high values on these underperforming, hard-to-sell assets produce inappropriate fees charged well beyond the investors’ originally intended holding period. For pension funds, these stale (higher than fair value) figures can affect management fees, prevent an accurate valuation of funds available for paying retiree benefits and tie up resources that could be invested elsewhere.

How the SEC is arming itself

The SEC has become increasingly aware of this situation as pension funds have increased their investments in such alternative asset classes, and they are beginning to take action. Bruce Karpati, chief of the SEC Enforcement Division’s Asset Management Unit explained at the Private Equity International Conference in 2013, “To launch this initiative, we used data about funds’ portfolios and looked for funds with unusually low liquidity compared to their peers. In examinations and investigations of the target funds, we look for misappropriation from portfolio companies, fraudulent valuations, lies told about the portfolio in order to cause investors to grant extensions, unusual fees, principal transactions, as well as other situations that concerned us. We think the zombie manager issue is significant and given the large amount of capital raised in 2006 and 2007, will likely become more important when those vintages reach maturity.”

It is clear that overvaluing assets could prove problematic for fund managers if the SEC does not find the proper documentation to support the reported figures.

How to prepare yourself: Professional, unbiased valuations can help

As the private equity industry has evolved, so have the valuation standards and accounting guidance available. Most newer limited-partner agreements (LPAs) establishing a private equity fund now require firms to provide quarterly and annual financial statements using Generally Accepted Accounting Principles (GAAP). These principles require financial statements to report the fair-value measurement of portfolio positions, using fair value as defined in Accounting Standards Codification (ASC) 820 – Fair Value Measurement. Depending on the conditions, auditors often require valuations of hard-to-value assets held by private equity funds to be performed by independent valuation professional.

Engaging an independent valuation firm helps avoid management biases while encouraging consistency, professionalism, due-diligence practices and depth of analysis. This naturally benefits investors, but it benefits private equity firms as well. Beyond averting the gaze of the SEC, this type of reporting helps build the reputation of the fund manager, creating a fundraising competitive advantage during the next round. On the other hand, firms known for holding and charging ongoing management fees on zombie funds will face increased difficulty raising capital in future cycles as the misalignment of fund manager and investor interests becomes clear.Using a professional firm also can help management in the audit process, reducing audit time and expenses.

In addition, regular professional valuations can help address other potential problems. Without strong valuation procedures:

• A fund’s net asset value could be inaccurate
• Large swings in net asset values could occur unnecessarily due to the sudden updating of stagnant valuations
• Poor internally prepared valuations and valuation practices could lead to litigation from investors and stakeholders
• Auditors might provide a qualified opinion to financial statements or refuse to issue financial statements altogether
• Institutional limited partners in private equity groups (those that need to produce GAAP-based financial statements), such as pension funds, investments funds and endowments, could not offer timely accurate performance reports to their boards, investors or beneficiaries

More frequent, independent fair value measurements are one of the tools needed to avoid zombie funds and the SEC examination and reputational damage they cause. As industry regulations increase and scrutiny continues, best-in-class firms will engage the expertise of independent, third-party professionals to analyze the hard-to-value assets, helping prevent a financial fright.

To explore this topic further, attend the webinar “Best Practices for Effective Fund Life Cycle Management” on September 30th at 2:30PM ET.  During the session, experts from Venable, AccuVal-LiquiTec and Newport Board Group will provide practical advice for both GPs and LPs on how to maintain alignment throughout a fund’s life cycle, with a focus on challenges faced by mature funds.  Click here to register for this free event.