“This is the part in the movie where that guy says, “Zombies? What zombies?” just before they eat his brains. I don’t want to be that guy.” – Holly Black in Kin
Usually referenced within the public investment realm, zombie companies are those “that earn just enough money to continue operating and service debt but are unable to pay off their debt” (thanks, Investopedia). One can imagine that a low interest-rate environment – where it’s relatively easy to keep debt service to a minimum – paves the way for the proliferation of zombie stocks. And, since most of the developed world was essentially in a zero-rate environment from the financial crisis until 2022, there is speculation that the living dead may be walking (or operating) among us. With that in mind, we’ll explore a variety of zombie-financial topics in this edition, with a particular focus on Alts. Here we go!
In your head, they are fighting
Especially thinking back to the start of our careers, many of us can relate to having existed as financial zombies at some point in our lives. Even if it’s not a dire situation of being saddled with unsustainable debt like zombie companies, many people have lived paycheck-to-paycheck; in fact, it’s estimated that 60% of US adults find themselves in that situation today. The initial suspicion may be that this phenomenon is limited to low-wage or unskilled workers, but data suggests otherwise: even highly skilled employees of upper-income tiers can be only a few missed paychecks away from financial demise. Is that entirely surprising, given that home affordability is at its lowest since 2007 (which we know was a pre-crisis real-estate bubble)? It’s not just in our heads. There’s a very real-world battle between the income and expenses of many households for uncovering adequate savings.
Is the US a zombie, eh, eh, eh?
I guess that depends on what your definition of “zombie” is. I’m in touch with plenty of people who share concerns regarding the long-term sustainability of the US from a business perspective (revenues vs. debt service). Even for those with no fear about the debt-laden journey the developed world has embarked on, one would have to be entirely ignorant of economics (or math, or common sense, etc.) in general, not at least to consider whether this approach can work indefinitely. It’s clear that the US (among other nations) has accumulated significant debt – which will become more expensive to service due to higher rates – and GDP is growing at a lower rate than where it was trending pre-2008, so we’ve been living amid some degree of zombification for years already (less growth, more debt). Are we, however, perpetually relegated to “full-on zombie mode” yet? Perhaps not, but it also won’t be an easy road ahead to return to declare ourselves safely in the land of the living once again.
A different sort of zombie
In the world of private investments, many funds (e.g., drawdown funds) set out to deliver returns within a finite time period. That fund life is usually somewhere between 7 and 10 years. Sometimes if a fund achieves a certain age, it may be granted some extra years of lifespan. So, for instance, you could have a 7-year fund that can tack on two 1-year extensions if it is ultimately in the best interest of the investors (LPs) or fund, in general. Thus, a 7-year fund can easily turn into a 9-year fund (or more), so it’s essential to be aware of the extension terms when investing. There are approval processes for these things, but if the fund management team (GPs) thinks the extensions are a good idea, I’d bet my money on the extended fund life happening.
At the same time, GPs cannot just snap their fingers and “kill” a fund. The reason drawdown funds have long lives in the first place is to allow time for GPs to create value within underlying holdings (e.g., companies or properties) before ultimately selling them (ideally at a gain). However, if the assets can’t be sold, the situation – and, therefore, the fund – can drag on longer than expected. That is known as a zombie fund. Very different than zombie stocks – which are trying to stay alive but perhaps shouldn’t be – zombie funds are trying to gracefully put themselves in the grave (aka “wind down”) but cannot do so until the portfolio has been fully liquidated. The common thread between the two, then, is a situation that is dragging on longer than it otherwise should.
Second things second
The initial goal is for a fund to meet or exceed its return and fund-life targets. When that fails, LPs and GPs may consider other courses of action. Remember, aside from being a nuisance to investors and managers, a zombie fund continues incurring expenses for ongoing management, accounting, compliance, legal, operations, etc., so there is an economic incentive to move forward.
We recently touched on secondary investments in “Warren Haynes and Secondary Gains.” For LPs, selling the fund in a secondary market – even at a steep discount – can be a reasonable way to avoid dealing with it any longer and doing away with performance reporting, fees, statements, and K-1s. That relief has value. However, this does nothing to solve the GP’s problem, as it merely means another investor now owns the fund’s shares.
For the GP to be able to end the fund, they need to get rid of what assets remain. They need a buyer, and the lack of a buyer (at least at the prices the manager sought) is why they’re in this predicament. In extreme situations – like during the Financial Crisis of 2008 – there may literally be NO buyers. Under more typical circumstances, however, a zombie fund may result from a manager struggling to find buyers at prices they deem reasonable for their investors.
Manage as if your livelihood depends on it
GPs aren’t paid incentive fees (aka “carry”) if their fund doesn’t perform well, so we can bet they’re trying hard to deliver good results to LPs. As this article points out, there’s some concern that rising rates may already be causing an increase in zombie funds and extending fund lives across the PE and VC spectrum. A low cost of capital – which was available from post-2008 to 2022 – can help companies drive higher profits and business valuations to increase. Conversely, a higher cost of capital (aka higher interest rates) can do the opposite. Therefore, funds that built their expectations upon a persistent low-rate environment may now find themselves with valuations far below target and unable to make money for investors or themselves…unless they can somehow sell underlying assets at once-anticipated higher values. What could be even worse for them is that selling assets at lower prices will solidify the failure of a fund and the inability to raise capital in the future – the death knell of a PE sponsor (aka GP, aka fund manager).
One way out
Why not take advantage of a good song reference when we can? One Way Out is best known because of the Allman Bros, but it was an older blues song recorded much earlier by both Sonny Boy Williamson and Elmore James. It tells the tale of a man in a house he shouldn’t be in with a woman he shouldn’t be with and needing to resort to exit via the window – an adaptive strategy, if you will. Similarly, GP-led secondaries may potentially be one way out for PE sponsors to wind down a fund, but it only works for assets they want to continue managing. Another of the manager’s funds can purchase existing holdings, but – unlike the song – this has to be very much on the “up and up” at fair prices for investors of both funds, as verified by third parties. Slipping out a window won’t cut it.
Can the zombie companies survive a persistently higher interest-rate paradigm? Can zombie funds find ways to wind themselves down that can protect their LPs and their livelihood? Will they all be thrown the lifeline of significantly lower rates in the years ahead? Are we all relegated to a zombified economic existence for centuries to come? I don’t know. All we can do is try to stay alert and protect our brains.
Until next time, this is the end of alt.Blend.
Thanks for reading,