BREAKINGVIEWS-Buyout zombie wave will favour the preppers

By Liam Proud

LONDON, Jan 21 (Reuters Breakingviews) - The message from the movies is clear: the most likely survivors of a zombie apocalypse tend to be those who are best prepared. A similar lesson may apply to the private equity industry, which is facing a rise in the number of "living dead" funds. These are firms that cannot raise a new investment vehicle and so end up sucking what they can out of old assets instead. EQT boss Per Franzén reckons 80% of his rivals may fall into this category. For pension plans and other big suppliers of capital to the industry, getting ready for the zombie wave will be less thrilling than stocking up on shotguns and shells — but potentially no less important.

Franzén is right that many buyout managers won't make it. PitchBook's database shows 15,000 active firms worldwide primarily focused on private equity - more than the number of McDonald's restaurants in the United States.

There simply isn't enough new money coming in to feed all mouths. Private equity fundraising last year was about $761 billion, preliminary Preqin data shows, down roughly a tenth from 2024. And a handful of behemoths like Advent International and Blackstone BX.N are sucking up a disproportionate share of the money. In the U.S., the 10 biggest funds drew 46% of all capital raised last year, according to PitchBook.

The pain is evident for smaller managers. Vestar Capital, owner of Texan animal-supplement seller PetHonesty, in late 2024 chose to focus on its existing assets instead of pursuing a successor to the $1.1 billion vehicle it closed in 2020, Buyouts Insider reported. Switzerland's Capvis, which owns Italian swimwear brand Arena, in 2024 said it would switch to a deal-by-deal approach rather than trying to raise a successor to its $1.4 billion 2018 vintage. Equistone, whose portfolio includes gift group Virgin Experience Days, struggled to raise a vehicle to follow its $3.3 billion 2018 flagship. Last year it decided to scrap its pan-European strategy and allow local country teams to go their separate ways to seek new money.

To be clear, these firms aren't classic zombies. They have not all thrown in the fundraising towel for good and decided to feast on their old assets. Breakingviews spoke to eight multibillion-dollar managers who have been unable to close a fund in at least five years. All expressed confidence in returning to the market one day.

But not everyone will be able to. PitchBook data shows almost 2,000 firms that raised funds between 2010 and 2021 but have not done so since. Meanwhile tail-end capital, which refers to assets sitting in vehicles that have already passed a fund's typical 10-year life, is racking up. The figure more than doubled between 2019 and 2024 to $829 billion, according to TREO Asset Management, an adviser that helps fund investors work through their tricky investments. That zombie capital is probably a hint of what's to come.

Zombie firms are a scary prospect for limited partners (LPs) — the sovereign wealth funds, pension plans and other institutions that put money into buyout vehicles. That's because once a private equity firm concludes that the latest fund may be its last, it has an incentive to string things out.

Imagine a poor-performing mid-market shop that raised $1 billion in 2021 and spent it on companies now worth $1.3 billion. The 20% performance fee or "carry" may not apply, since there is typically a minimum hurdle return of 8% or so required in most fund documents, giving the manager little incentive to sell. Yet the annual management fee, often 2% of invested capital, could provide an income stream worth $20 million a year until 2031, since funds usually have a 10-year life. It doesn't take a buyout whiz to see that the rational thing to do is sit on the assets at the LPs' expense. The manager can kick the can further by moving unsold assets into a so-called continuation vehicles, resetting the timeline and in some cases also the performance fee hurdle.

Lawsuits cannot really help LPs in this situation, industry advisers told Breakingviews. The contracts governing private equity vehicles often contain waivers of fiduciary duties. That helps to explain why such a high-stakes industry has seen so little litigation between managers and LPs: one recent academic study found that just 4% of lawsuits against private equity firms, from a sample of 153 cases, came from the underlying investors.

A better, though still tricky, option is to fire the buyout firm squatting on the assets. This would involve triggering a "no-fault divorce" clause, which allows LPs to remove the manager and install another one to wind down the portfolio. A 2020 LP survey by industry body ILPA found that 71% of respondents had such provisions in at least half of their investments. The voting thresholds are high, though. Support of 75% of LPs, measured by committed capital, is often required.

James O'Donnell, a Gibson Dunn lawyer who works with LPs, says gaining such a level of consensus is difficult. "Often there are conflicting interests between LPs", he told Breakingviews. For example, big LPs may view any single disappointing fund as a rounding error on their wider portfolio. Others may have cash tied up in other vehicles with the same manager, making them unwilling to rock the boat. The upshot is that firing managers is much rarer than in other arms of the asset management industry, like listed UK investment trusts, where a simple majority will often do.

A general rule of thumb for LPs, according to TREO Chief Investment Officer Finbarr O'Connor, is that it's best to address potentially tricky situations with private equity managers as quickly as possible. Early warning signs that things may be going awry at a fund include lower levels of transparency or key staff members jumping ship. If that's happening, it makes sense to get organised, including by trying to find out who the other LPs in the fund are. The mere threat of co-operation between investors can sometimes change a buyout managers' behaviour.

There may even be a case for paying zombie managers to go away if they're not moving quickly enough to liquidate the portfolio, one fundraising adviser told Breakingviews. The trick is agreeing on a number that's big enough to matter for the buyout baron, but not too big that it wrecks the investors' returns. Paying for failure may sound odd, but it's preferable to getting dragged along indefinitely by the living dead.

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