Two years ago, reporter Matt Taibbi of the progressive media publication Rolling Stone referred to Goldman Sachs Capital Partners, the second largest private equity firm in the world, as a “great vampire squid wrapped around the face of humanity.”
And earlier this year, Gideon Rachman of the conservative newspaper Financial Times called Mitt Romney, current presidential candidate and co-founder of Bain Capital (the world’s seventh largest private equity firm) “deadly dull.”
Vampires? The deadly dull? The private equity industry appears to be experiencing more than its fair share of comparisons to the dead … not to mention the undead!
It’s difficult to feel sorry for private equity professionals, though, considering the zombies that they have unleashed on the investment community.
Little or No Income
Fortunately for humanity, the zombie funds of the private equity industry do not feast on human victims, as do the undead antagonists in horror films like The Night of the Living Dead. Investment zombies behave more like the creatures of African and Haitian voodoo legends, i.e. like individuals who calmly and peacefully move among the living even though they are no longer alive.
So what, exactly, is a private equity zombie? It’s a fund that has passed beyond its legal target date of termination and yet continues to exist despite producing little or no income. Nevertheless, as long as it remains in operation, its investors are legally required to continue paying management fees to the private equity firm.
In other words, it’s a vehicle that earns revenue for its investment managers without earning returns for the investors who contributed the original capital. Like an undead zombie that remains in human society but that does not contribute constructively to human endeavors, a zombie fund remains in investment portfolios but does not contribute to investment returns.
First Condition: Termination Date
The continuation of the existence of any zombie fund is reliant on a pair of conditions. The first involves the employment of a target date of termination for the investment vehicle. And the second involves the right of the private equity firm to maintain the funds for an indefinite period beyond the termination date.
Traditional equity investments, of course, do not carry termination dates at all. Instead, debt transactions (such as bank loans) encompass the traditional methods of raising funds in a manner that requires repayments on specific future dates. Equity transactions, on the other hand, encompass the traditional methods of raising funds through the sharing of ownership interests. So why do private equity zombie funds establish any dates of termination?
It is because private equity managers, by definition, maintain relatively short term investment horizons. They are different from long term financiers like the illustrious Warren Buffet, who seek to invest in firms with stable intrinsic valuations, and who might continue to hold equity interests in such firms indefinitely. Instead, private equity managers seek turnaround situations where they can purchase underperforming firms, improve their levels of performance within three to five years, and then resell the firms for a profit.
When equity investments are only designed to be held for a few years, it does make sense to create target dates of termination to reflect such brief time frames. Thus, private equity managers have decided to insert such dates into many of their funds.
Second Condition: Indefinite Existence
But if target dates of termination are assigned to many private equity funds, why would investment managers continue to maintain the funds beyond those dates? Wouldn’t the investors who provided the original capital for those funds prefer that the assets be liquidated, and that the proceeds be returned to them? Why would they prefer to continue paying fees on funds that are failing to earn significant returns?
Investors would, without any doubt, prefer to liquidate zombie funds. In fact, last week, the Wall Street Journal reported that pension funds are now attempting to sell off their zombies in secondary markets for whatever proceeds they might receive for them. But even if new buyers purchase those funds, the private equity managers would continue to operate them, and would continue to charge management fees in accordance with their provisions.
During the most heated moments of the recent mortgage backed securities scandal, Goldman Sachs and other financial investment institutions were accused of betting against their own investors and taking positions that would allow the institutions to prosper even though their clients’ investments might fail. Warren Buffet later defended this laissez faire philosophy, declaring that “it shouldn’t matter who is on the other side of a deal.”
As long as this philosophy continues to pervade the global financial system, zombie funds are likely to continue haunting the portfolios of investors. If you are an investor who would be unnerved by such “undead” investments, please remember to check your fund prospectus for each condition before you commit your capital