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June 7, 2012

Investors beware of zombie funds

by: Motley Rice

To clarify from the outset, zombie funds aren’t the antagonists of a bad Hollywood movie about the living dead overtaking Wall Street. In reality, they are lifeless funds that can feed on investors’ returns.

Zombie funds are funds involving money managers that continue to get paid even though the funds are effectively inactive. While nothing new, the recent resurfacing of these funds has caused a stir. Funds become inactive when their managers, typically private equity firms, either park assets that cannot be sold or choose not to sell them because their valuations are so low or difficult to price. Investors’ money is locked into a dwindling asset with little chance of ever turning a profit. The problem can become even more frightening if private equity firms artificially inflate values to ensure they collect management fees.

To the horror of watchdogs, zombie funds may be more prevalent than once believed. As proof, investors should read The Wall Street Journal’s Sandra Pulliam’s excellent report on zombie funds. She found that public pension funds, which are significant private equity investors, may be particularly vulnerable to the clutches of zombie fund. The zombie funds can tie up investment dollars that might otherwise be available to help a public pension fund’s retired beneficiaries.

I recommend watching her three-minute web video describing her recent investigation. Pulliam notes that an army of zombie funds has risen from the grave. Approximately 200 private equity funds created over the past decade qualify as zombie funds, which equates to more than $100 billion in so-called investment assets. An earlier Financial Times article goes even further, claiming that about half of all institutional private equity investors have a stake in a zombie fund.

Fund managers have no incentive to get rid of these assets because, if the assets are priced at fair value, the managers may have to show a loss. Private equity firms also would be relinquishing easy management fees. These factors have caused concern about the possibility of private equity firms manipulating the value of investments to prop up these zombies.

The potential for abuse prompted recent comments by SEC enforcement director Robert Khuzami, who said in an interview with C-Span Television, "We are going to take a close look at that and see whether or not there's a problem." (The zombie funds discussion begins at the 16-minute mark).

While regulators and others investigate zombie funds, some investors are already the taking the following courses of action:

  • Ax management fees – Pension funds can ask fund managers to lower fees. The Illinois State Board of Investment recently demanded that Invesco stop charging fees on an apparent zombie fund. Illinois was able to cut its annual fees by about 90 percent.
  • Vanquish the investment – Pension funds may ask the private equity firm to liquidate the fund. But as a spokesperson for Illinois noted, the end result may be that pension funds are left holding the worthless stock certificates of private companies. Pension funds could also sell their stakes in zombie funds, though that may result in trades at significantly lower prices than the funds’ managers value them.
  • Take the battle to the zombies – Unlike a public company involving investors that often have limited forums to kick-start change, private equity investors might directly engage with the management of the underlying lifeless assets.

Zombie funds may be a comical take on the living-impaired, but the impact on pension funds is no laughing matter. Investors should remain vigilant.

Authored by David Abel, a Motley Rice attorney from 2010 to 2016.