The Securities and Exchange Commission has a shotgun in its hand and is looking for zombies. “We are going to take a close look at that and see whether or not there’s a problem,” said Robert Khuzami, the SEC’s enforcement director. Khuzami is the one pointing the shotgun.
Many private investment funds either prevent redemptions or have some limit on redemptions. That gives the fund manager a better ability to make a long term investment. Otherwise, the fund manager’s ability to invest will be subject to the short term withdrawals of its limited partners. A typical equity mutual fund can allow broader redemption rights because its investments in the stock market are very liquid and easy to value. At the other extreme is a real estate fund. Buying and selling real estate takes weeks and often months to settle. The business plan for a private equity fund or venture capital fund investment may run for a decade.
Private investment funds will typically have a lifespan of many years with the ability of the fund manager to extend that lifespan. During the lifespan, the investor/limited partner has no contractual right to get its money back. This limitation is magnified for investors in a fund of funds. The fund of funds manager is stuck with whatever the underlying fund manager is doing.
Although the limits on redemption are needed, that doesn’t mean that there is no abuse. A few fund managers may have let the fund turn into a zombie and merely sit back and collect management fees.
“We’re looking at zombielike funds that potentially have stale valuations,” says Bruce Karpati, co-head of the SEC’s asset-management enforcement unit. “The investigation into zombie funds is an important effort being driven across the country.”
From a compliance perspective, improper valuations are the most likely source of trouble. Overvaluing assets will increase management fees. An examination by the investors or the SEC will be a problem if the fund manager cannot document and justify the valuations. The SEC has made many public statements that it will take a close look at the valuation practices of private investment funds.
If you’re a zombie fund manager, lookout. The SEC is hunting the walking dead.
Sources:
- SEC says taking “close look” at zombie funds from Reuters (Reporting by Rachelle Younglai; Editing by Jan Paschal)
- Investor Hazard: ‘Zombie Funds’ by Susan Pullman and Jean Eaglesham in the Wall Street Journal
- Hedge Funds of the Living Dead by Jay Eisenhofer and Matthew P. Morris in the NYTimes.com’s DealBook
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>Letter from the Illinois State Board of Retirement to Invesco
- (.pdf) from the
Wall Street Journal
- Zombie image is from the Centers for Disease Control and Prevention, part of the United States Department of Health and Human Services
