This blog post originally appeared on Burgiss.com. MSCI acquired The Burgiss Group, LLC in October 2023.
Although a 10-year term is a common feature of private-capital-fund limited partner (LP) agreements, funds usually take significantly longer than that to fully liquidate; these zombie assets can continuously shuffle along through multiple extensions.[1] For LPs considering selling zombie assets onto the secondary market, the big question is: Are general partners (GPs) clinging to these overstated zombie valuations, and thereby postponing eventual write-downs, or should LPs ultimately expect this capital to be distributed in full? In this blog post, we present evidence that zombie assets are, on average, appropriately valued.
GPs’ zombie valuations are close to the mark
We call a fund a zombie if, at age 10, its reported net asset value (NAV) is at least 10% of the original commitment amount. There are a couple of reasons why some LPs may think that GPs are systematically overvaluing zombie assets: GPs may be overly optimistic or they may be strategically trying to extract more fees for the same work.[2] Once a fund’s NAV drops to 1% of the commitment, we consider it to be quasi-liquidated, at which point we can evaluate whether GPs had intentionally overvalued their zombie assets.
One way to test these valuations is to look at the internal rates of return (IRRs) for funds in their zombie phases, as illustrated in the following exhibit.[3] An IRR of zero means the valuation at age 10 was exactly right, a positive IRR suggests that the assets were written up and a negative IRR suggests the assets were written down. We find that IRRs were above zero in all three asset classes (venture capital, buyout and real estate); however, median IRRs were closer to zero.[4] This data demonstrates that GPs have been relatively accurate when valuing zombie assets.
Probability density of IRRs from age 10 until 1% quasi-liquidation
Although the average fund appears to be accurately valuing its holdings, LPs may worry that this is untrue for funds that underperformed during their first 10 years. Using fund private market equivalents (PMEs) from inception to age 10, we divide funds into “good funds” — funds that outperformed public equities[5] — and “bad funds” — those that did not.
The following exhibit suggests that even bad funds distributed their reported NAV in full but good real-estate and venture-capital funds significantly outperformed. While these findings are encouraging for LPs with zombie exposure, a word of caution: the risk of large write-downs was substantial, and this risk was greatest for bad funds, as evidenced by the meaningful mass of funds with negative IRRs since age 10. Approximately 30% of bad funds yielded zombie IRRs below -10%, compared to just 20% of good funds.
Distributions of IRRs from age 10 until 1% quasi-liquidation
Little reason to fear zombie assets
Despite concerns that GPs might overstate valuations of zombie assets, we find little evidence that this was a systematic practice. Even underperforming funds appeared to be accurately valuing their zombie assets, on average. However, risk managers should keep in mind that there remains substantial potential for write-downs, especially among funds that have already underperformed.
The author thanks Brooke H. Jones and Henry Phan of Bryn Mawr College for valuable discussions on the topic.