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Night of the Living Dead Money

by David C. Erroll
Eyes on Wall Street |
Active investor engagement is essential to identify the red flags common among zombie private equity fund abuse.
In a recent interview with Bruce Karpati, Chief of the Asset Management Unit at the SEC's Enforcement Division, the investment watchdog reaffirmed the agency's commitment to policing so-called "zombie private equity funds"-old, small funds that are nursed along to provide management fees rather than returns to investors. Any progress in cracking down on zombie fund managers will turn on investors' willingness to conduct or commission periodic reviews of their private equity portfolios.

Just as private equity management company IPOs such as Carlyle Group and Blackrock have proved popular with investors, unlisted private equity funds have become
a far more important piece of the institutional portfolio. But with the greater expected returns of private equity fund participation come greater risks, and not only from the underlying business investments: private equity funds often require long lock-up commitments, offer little or no liquidity, and can afford investors less visibility into the fund manager's operations than traditional stocks.

A further risk turns on the extent to which institutional investors themselves can monitor a fund's performance. Private equity funds that lose or pay out much of their capital may represent a tiny portion of the institution's portfolio or be written off altogether, becoming zombie funds. Once zombie funds are below the radar, the risk rises that the fund will be abused by managers to extend the stream of fees-or worse.

In 2012, the SEC brought a number of enforcement actions against zombie fund managers for fraud, ranging from the subtle (misappropriating zombie fund gains to pad profits at viable funds) to the blatant (theft of fund assets). Many of these claims, however, rely on active investor engagement to identify the red flags common among zombie private equity fund abuse, such as poorly justified extensions to fund operations and increasingly opaque profit and loss reports.

As the Federal Reserve's zero-interest-rate policy enters its fifth year, institutional investors find themselves increasingly pressed toward less conventional areas of the market to meet their investment goals. By taking steps to mitigate the attendant unconventional risks, such as scheduling annual reviews of small positions or establishing a third-party monitoring plan, private equity fund investors can avoid the zombie fund pitfalls as they diversify into higher-yielding areas.