Zombie funds rise as small funds delay exits, struggle for capital

Prolonged asset holding weakens fund returns as fundraising declines.

The rise of "zombie funds"—small and mid-cap funds that delay exits in hopes of better valuations—is becoming a growing concern in private equity. As fundraising declines and managers struggle to raise new capital, these funds are holding onto assets longer, impacting fund performance and investor returns.

“This prolonged holding over time really deteriorates, typically, the IRRs of the fund,” said Sam Padgett, Head of Private Equity Origination for Asia Pacific at Deloitte. “The longer you hold an investment, the harder it is for you to get the higher kind of mid-20% return targets that you're searching for.”

Padgett noted that the incentive structure of these funds weakens when managers lose hope of raising a new fund. “There's less incentive for them to return capital to the LPs, so lower returns is maybe less of a consideration for those fund managers than a fund that's going out to raise new money,” he added.

While zombie funds present challenges, regulatory risks remain low since these are private funds governed by Limited Partner Agreements (LPAs).

“So it's really a private agreement between those funding, the general manager of the fund, and the deal teams that are making investments,” Padgett explained. “If they run out of time for that fund and don't have capital to give back to the LPs, they might end up having to put the asset back to the LPs.”

This, however, creates a problem for pension funds and sovereign wealth funds, which prefer to act as investors, not asset owners. “Ultimately, these pension funds or sovereign wealth funds don't really want to be asset owners,” Padgett said. “They're investors, not operators.”

Raising new capital has become increasingly difficult for small and mid-cap funds, leading to a higher risk of funds becoming inactive.

To survive, small funds must find ways to differentiate themselves. “There are some strategies they can try to become niche experts in specific sub-sectors as a way to attract that money,” he said. However, for many, it may simply take time for LP money to flow back into the market before they can successfully raise new funds.