By Dawn Lim, Layan Odeh and Linly Lin
(Bloomberg Businessweek) — In its heyday, Fenway Partners snapped up a fleet of companies from outposts overlooking Manhattan and Los Angeles. Decades later, a three-man team manages its remnants from a beach town in Rhode Island.
Gone are the big pension clients that cashed out stakes at discounts after tiring of waiting for Fenway to wrap up bets. The firm hasn’t tried to raise a new flagship fund since 2006. Its main asset is a 20-year investment in a maker of football helmets beset by lawsuits from athletes over concussions. Fenway set up new vehicles to take stakes in the business starting several years ago, gaining yet more time to exit.
Across the $12 trillion industry, hundreds of private equity firms are lumbering on years after their funds’ intended twilight with no new fundraising in sight — a cohort that investors and regulators have dubbed “zombies.”
Now, a historic shakeup of the industry is threatening to impose the same fate on more fading money managers whose past funds are inching toward limbo.
After years of ramping up allocations that helped launch numerous private equity firms, many pensions have maxed out how much they can devote to the illiquid asset class. Instead, they’re steering cash to investments that are more attractive as interest rates climb.
The result: Buyout firms that failed to build fresh war chests during the recent boom years of low interest rates are now finding it difficult to arrange fresh funds. The industry is on track to raise 28% less than last year, according to Bain & Co. At the same time, aging funds are finding it harder to sell out of their remaining holdings as rising borrowing costs sideline potential buyers.
Across the nation, public pension funds are stuck with a slew of private equity holdings that, for a variety of reasons, keep plodding on year after year. They include vehicles set up by energy-sector specialist First Reserve and Yucaipa Cos, the money manager led by supermarket mogul and Democratic donor Ron Burkle.
“This is the market where you could see several zombie funds emerge,” said Joncarlo Mark, founder of Upwelling Capital Group, an adviser to investors and managers on older holdings. “When things go sideways it creates a downward trajectory.”
If money managers don’t launch new flagship funds or find other ways to shore up their fees, they can eventually lose staffers en masse, leaving a skeleton crew behind to resolve old bets and manage bills. Funds — typically designed to last no longer than 12 years — end up going long past expiration dates, with firms sometimes sliding assets into continuation funds to keep managing them. It creates headaches for clients, who have to decide whether to press for an exit or hang on, hoping things turn around. The steep discounts to ditch problematic fund stakes prompt many investors to spend years crossing their fingers. “It’s important to realize that not everyone associated with a zombie lacks capabilities,” Mark said.
In Fenway’s case, one big bet — the helmet maker Riddell, now known as BRG Sports — proved hard to sell. Fenway went with the best alternative to a forced sale, and investors who stuck around will end up happy, said Walter Wiacek, the firm’s chief compliance officer. He rejects the notion that the firm can be described as a zombie, but past clients and former executives say it fits the bill.
Years-long delays have become common in the industry. Private funds that launched before 2010 still held roughly $80 billion as of last year, according to Preqin. And there are now 645 firms that haven’t raised a new buyout vehicle since the start of 2015. “If you haven’t raised a new fund in the last five years, the perception is you may become a zombie,” Todd Miller, co-head of private capital advisory at Jefferies Financial Group Inc. “You need to raise new capital to feed the junior team.”
Zombies are pretty much unique to money managers who make illiquid, complex wagers. In contrast, funds that pick stocks and bonds can collapse relatively swiftly after major missteps and an exodus of investors. Sticky bets can create dilemmas. Pensions and endowments can’t force private equity managers to sell. They can’t pull money from a fund without typically paying a price. Nor can they replace a manager unless there’s evidence of wrongdoing. That means zombie funds can go on for years, sucking up pension managers’ time and eroding returns.
Reports from 10 major public retirement systems show that they have a median 4% of their private equity portfolios locked up in funds older than 2009. Collectively, that’s $6.8 billion across more than 900 fund investments, some of which date back to the 1990s. Several funds were so troubled that they were delivering losses.
“Fund lives are going much, much longer,” Miller said. And with asset sales now more difficult, many managers face the same questions: “What, when and how are they going to exit?” That’s an inconvenient counterpoint to private equity’s pitch that it can reliably take cash from teachers, police,
firefighters and other civil servants and hand it back with significant returns a decade later.
Longtime friends Peter Lamm and Richard Dresdale named Fenway in honor of the Boston Red Sox baseball stadium when they launched the firm in 1994. Their investments included the companies behind Simmons mattresses, Van de Kamp’s fish sticks and home-delivered contact lenses, establishing themselves as part of a new generation of private equity dealmakers.
The turning point came when Riddell was sued. Pensions got jittery and wanted out. It didn’t help that the US Securities and Exchange Commission said in 2015 that Fenway failed to disclose it diverted millions of dollars from investors, prompting the firm and certain executives to pay more than $10
million to settle the claims. They didn’t admit or deny the agency’s findings.
Fenway clashed with investors over how much to take in profits. Dealmakers departed. Fenway set up new funds to take over BRG, calling it a way to recapitalize older bets. In 2018, investors in the 1998 fund faced a choice: transfer into the new fund, let Hollyport Capital take over their stakes at about 50% discount, or do nothing. The vast majority of Fenway’s investors — accounting for 97% of the money
— decided to get out. The firm repeated a similar playbook in 2019 for another fund. Hollyport, a specialist in buying old stakes, is now Fenway’s biggest investor.
Today, Fenway operates from a tidy office park along a picturesque tree-lined road by Westerly State Airport near the westernmost tip of Rhode Island. The firm said it’s collecting only modest fees. Hollyport has given Fenway an incentive to resolve the bet on the helmet maker successfully, agreeing to give the shrunken money manager a chunk of the profit if it sells the company above a certain price. “We work very hard for investors,” Wiacek said. “I’m confident when we exit the two funds, investors will be very pleased with the results and they will not have any regrets having retained their interest.”
Steve Nicholls, senior investment partner at Hollyport, said his firm essentially reset the clock on Fenway’s investment.
“Fenway has done a good job in managing the asset,” he said. BRG “needed the time to develop the business and clarify their issues — and that’s the time we’re willing to give them.” A BRG spokesperson said the helmet maker has grown under Fenway, is committed to improving protection for athletes, and that given its market share and innovation, “the future is bright for the company and the game, too.” Fenway’s holding has been gaining value in recent years, a person with knowledge of the matter said.
The industry’s first wave of zombies arose after the 2008 financial crisis, when buyout firms struggled to persuade recession-scarred customers to contribute to new funds. The SEC eventually called out such money managers for prioritizing their need to keep generating fees from old funds over what was best for clients.
“Since zombie managers are unable to raise new capital, their incentives may shift from maintaining good relations with their investors to maximizing their own revenue,” Bruce Karpati, then the head of the agency’s enforcement group specializing in asset managers, warned in 2013.
Another wave is taking shape with pensions, endowments and other institutions steering less cash into private equity. Pensions now have so many options that they’re taking little chance on small, untested firms or those with blemished histories.
“If a manager has not been able to raise money in good times, you wonder about the quality of their fund,” said Fabrice Moyne, who led secondary investments at money manager Mantra Investment Partners until 2022. “You ask yourself how well they’re going to manage assets and how much value they’re going to be able to generate.”
Pension funds stuck with aging investments don’t have many good options.
North Carolina’s state pension, for example, stands out with a $780.9 million exposure to funds launched before 2009 — about 11% of its private equity portfolio. The $175.6 billion system dramatically slowed the pace of new fund investments after Treasurer Dale Folwell took office in 2017. Folwell rode a motorcycle during his election campaign tour and vowed to save the state money.
“I refuse to sell any of our vintage limited partnerships at deep discounts, which our investment management team has determined not to be in the best interest of those we serve,” he said in an interview.
Staying on doesn’t guarantee a better outcome. The California Public Employees’ Retirement System, the nation’s largest pension, committed roughly $900 million to funds launched more than 15 years ago by Burkle’s Yucaipa. Two of those investments — to which Calpers pledged almost $300 million — are under water, according to Calpers’ website.
The pension system explored offloading the stakes to second-hand buyers in the past year, but didn’t find an acceptable bid, according to a person with knowledge of the situation. A Yucaipa spokesperson said Calpers approached Burkle to invest in underserved communities in California, and the performance reflects the constrained mandate. He disputed any suggestion the funds are zombies, adding that one had a “liquidity event” in the past year.
The pension’s big checks to Yucaipa boosted its stature as a pension manager back in the day. Yucaipa hasn’t raised a new flagship private equity fund since 2015. The Yucaipa spokesperson said that reflects Burkle’s desire to return Yucaipa to its roots as a family office. The firm launched a so- called blank-check company — known as a SPAC — three years ago.
Many older funds missed their chance to sell assets to buyers with access to easy financing, leaving them saddled with holdings going further past their prime. “There’s a continuing slowdown in the mergers and acquisitions and IPO markets, which makes certain assets harder to sell out of private equity funds,” said Holcombe Green, who heads Lazard’s private capital advisory business. “That could create more old assets inside of those funds.”
One upside for fund managers: Hanging on to assets can generate fees.
Take First Reserve. The private equity firm raised the biggest energy fund of its kind in 2009 and rose to become one of the most active players in the patch when oil prices rallied. But the firm’s fortunes changed when oil prices plunged and the SEC rapped it for failing to disclose conflicts of interest.
In 2017, First Reserve sold its infrastructure business to BlackRock Inc., and its star team joined the asset manager. Later came the explosion of a chemical plant, in which a First Reserve fund owned a stake. The fund, which once collected roughly $9 billion, was written down by half, according to people with knowledge of the matter. The fund stopped collecting fees and is now in liquidation, one of the people said.
Last year, First Reserve shifted the plant operator and other bets into a continuation fund. Buyout firms often pitch such funds as a way to keep some of the best bets going. Such a move can give managers more time to salvage underperformers, but it also guarantees a fee stream. The plant has since filed for bankruptcy.
For investors, the other option was to cash out for less than 40 cents on the dollar, the people said. The fund manager presented this to investors as a way they could get some liquidity.
Read more: Private Equity Deal Rut Spurs Firms to Raise Cash Creatively
The firm faces other challenges. Its 2014 fund is underwater and still is holding on to about one out of every three bets it made, one of the people said. First Reserve raised just a fraction of what it hoped to raise for its latest fund. The pandemic temporarily reduced demand for oil and made energy funds less appealing for investors.
Firms or funds that become zombies often do so quietly, years after they’ve left the limelight. They’re easy to overlook at a time when Wall Street’s marquee names and a swath of boutique private equity firms are conspicuously thriving. Blackstone, which passed $1 trillion of assets in July, has seen its stock soar 50% this year.
The big firms are benefiting as small firms fall by the wayside. Since 2020, funds with less than $1 billion have drawn a shrinking share of the industry’s annual fundraisings, while funds exceeding $5 billion garnered more.
“The inclination by investors,” said Upwelling’s Mark, “is to commit to managers they know best.”
Note on methology: Bloomberg News calculated the weights of older funds within 10 pensions’ private equity portfolios, relying on their most recent public reports of such holdings. When calculating the remaining value of funds launched in 2008 or earlier, items with negative market values were excluded. This prevents the worst performers and funds in the red from skewing results. Funds of funds are included if pensions report such items as part of their portfolios. Those kinds of vehicles — investment funds that commit to other funds — typically have longer holding periods than traditional private equity funds. The ages of pensions’ stakes in funds are based on the vintage years of the holdings. In the case of the Washington State Investment Board, vintage-year data wasn’t available, so ages were derived from the year in which Washington entered into the investments.
Bloomberg studied the private equity portfolios of the following institutions: California Public Employees’ Retirement System; California State Teachers’ Retirement System; North Carolina Retirement Systems; Washington State Investment Board; Oregon Public Employees Retirement Fund; Pennsylvania Public School Employees’ Retirement System; Teachers’ Retirement System of the City of New York; New York City Employees’ Retirement System; Florida State Board of Administration; Connecticut Retirement Plans and Trust Funds.
–With assistance from Miles Weiss.
The article was originally posted at Bloomberg.com.
