The Zombie Fund Problem Is Finally Getting the Attention It Deserves

I’ve been using the term “zombie funds” on this program for years. Now the financial press is catching up, using the exact same language. Better late than never, I suppose. But let’s be clear about what’s actually happening here and why it matters to anyone who has money parked in private equity.

The net asset value of U.S. private equity assets stuck in funds at least a decade old has reached an all-time high of $348.5 billion. That’s roughly three and a half times the amount in 2015 and nearly one hundred times the amount in 2005. This isn’t a small corner of the market. This is a systemic problem that was entirely predictable.

How Private Equity Built a Business Model on Borrowed Time

Here’s what happened. Many fund managers launched vehicles in the mid to late 2010s and then went on a buying spree in 2020 and 2021 when interest rates were sitting near zero. They paid peak prices for everything from HVAC companies to doctor groups to financial advisory firms. Some of those valuations were, to put it charitably, obscene.

I said at the time that the entire business model got thrown into a wood chipper the moment rates moved off the floor. That’s exactly what happened. Here’s why:

• Private equity depends on cheap debt to juice returns. When borrowing costs rise, the math falls apart.
• Valuations were set at peak market conditions. Buyers today are not willing to pay those prices at higher borrowing rates.
• Funds have exceeded their typical lifespans. They can’t raise more money, they can’t acquire new assets, and they can’t sell what they own at prices they’d accept.
• Fund managers are still getting paid. The classic two-and-twenty fee structure keeps churning out compensation for the managers, regardless of whether investors can cash out.

The People Getting Paid vs. The People Getting Hurt

Here’s the part that should make your blood boil. The fund managers are not suffering here. They’ve been collecting their two percent management fees the entire time. They would have made more money if they could have exited cleanly, sure, but they’re not broke. The investors eager to cash out? That’s a different story.

I can’t fault a small business owner who sold at an insane multiple. If someone is willing to write you a check at a ridiculous valuation, you take it. That’s not a moral failing. But look at what happened downstream:

• Doctor groups sold to private equity and now the patient-doctor relationship has deteriorated badly.
• Financial advisory firms sold to private equity and the results for clients have been a mess.
• Business owners cashed out while the funds that bought them are now unable to exit at anything close to what they paid.

Now They’re Creating Funds to Manage the Zombie Funds

And here’s where it gets almost comedic. The industry’s response to the zombie fund problem is to create new funds specifically designed to manage the zombie funds. New fee layers on top of a broken structure. This is Wall Street’s version of a solution, which is to say it’s really just another product to sell.

The secondary market for private equity is supposed to provide liquidity, but when you’re trying to move assets at peak valuations in a higher-rate environment, buyers simply aren’t showing up at the prices sellers need.

What You Should Take Away From This

If you have exposure to private equity, particularly through older vintage funds from the mid to late 2010s, you need to understand a few things:

• Liquidity is not guaranteed. Private equity has always come with lockup periods, but “zombie fund” status means those periods are extending indefinitely.
• Valuations may not reflect reality. Without an active transaction market, the numbers on paper may be significantly higher than what you’d actually receive in a sale.
• Fee structures favor the manager, not you. Even in a distressed environment, the two-and-twenty keeps running.
• Complexity is not sophistication. The private equity pitch often leans on exclusivity and complexity as proxies for quality. They are not the same thing.

I’ve been saying this for years. The music stopped, and a lot of investors are still standing.