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Rise of Zombie Funds and Concerns Over NAV Financing Impact Private Equity Market

Nearly 50% of private equity investors have funds stuck in zombie vehicles, with 64% expecting manager mergers.

By Barry Stearns

6/11, 08:11 EDT
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Key Takeaway

  • Nearly 50% of private equity investors have funds tied up in "zombie funds," with 28% expecting more to appear soon.
  • 57% of investors are concerned about NAV financing, fearing it introduces costly leverage and dilutes returns.
  • Higher interest rates and inflation are driving consolidation, with 64% of limited partners expecting mergers or acquisitions among private equity managers.

Rise of Zombie Funds

Investors in private equity are increasingly encountering "zombie funds," according to a recent survey by Coller Capital, a secondaries asset manager. The survey revealed that nearly 50% of pension funds, insurers, and other investors already have money tied up in funds with little hope of liquidating their assets or raising a successor vehicle. Additionally, 28% of respondents expect to see such funds appear in their portfolios in the near future.

The report attributes this trend to recent economic conditions, stating, "Recent years, marked by inflation and high interest rates, have no doubt had an unfavorable impact on portfolio companies’ growth prospects, which could lead to an increase of zombie funds." Coller Capital surveyed 110 private equity investors, also known as limited partners, across North America, Europe, and Asia. The firm manages $33 billion, making it one of the largest investors in the secondary market, which allows investors to exit their private equity positions before the funds are wound up.

The survey's findings come at a critical time for private equity. Higher interest rates have made capital more expensive for both buyers and sellers, complicating the process of exiting investments and increasing financing costs for portfolio companies. About 64% of the surveyed limited partners believe that at least one of the private equity managers they are currently invested with will merge with or be acquired by another manager within the next two years.

Concerns Over NAV Financing

The survey also highlighted concerns among investors regarding the use of Net Asset Value (NAV) financing in the private equity industry. Approximately 57% of investors expressed discomfort with NAV financing, citing the introduction of additional leverage into the system as a primary concern. NAV financing allows private equity firms to borrow against a pool of their portfolio companies, a practice that has ramped up as traditional borrowing options have dried up. These loans are typically costly, and critics warn that they are likely to dilute returns in the long run.

The increased use of NAV financing reflects the sector's adaptation to a more challenging borrowing environment. However, the potential for diluted returns has raised red flags among investors. The survey's findings underscore the need for private equity firms to carefully consider the implications of leveraging their portfolios through NAV financing.

Impact on Private Equity Market

The rise of zombie funds and the increased use of NAV financing are indicative of broader challenges facing the private equity market. Higher interest rates and inflation have created a more difficult environment for private equity firms to operate in. These economic conditions have not only made capital more expensive but have also impacted the growth prospects of portfolio companies, leading to a rise in zombie funds.

The survey's findings suggest that the private equity market may be entering a period of consolidation. With 64% of limited partners expecting mergers or acquisitions among private equity managers, the industry could see significant changes in the coming years. This potential for consolidation reflects the pressures that private equity firms are facing as they navigate a more challenging economic landscape.