Private Equity's Zombie Company Crisis and Liquidity Constraints: Systemic Impacts on Fund Performance and LP Returns

The private equity industry, long celebrated for its role in revitalizing underperforming businesses and driving capital efficiency, now faces a paradoxical crisis: the proliferation of "zombie companies" and "zombie funds" that threaten to undermine its core value proposition. These entities-businesses barely covering debt servicing costs and funds outliving their intended lifecycles-have become systemic risks, distorting fund performance metrics and eroding returns for limited partners (LPs). As liquidity constraints tighten and exit markets stall, the implications extend beyond individual portfolios, challenging the broader financial ecosystem.

The Rise of Zombie Companies and Funds

Zombie companies in private equity portfolios persist due to a combination of reputational concerns, liquidity constraints, and complex capital structures, according to a Clifford Decker alert. These firms drain capital, stifle innovation, and amplify fragility during downturns. Simultaneously, zombie funds-older private equity vehicles with elevated net asset values (NAVs) but minimal distributions-have become increasingly prevalent. By 2024, over half of these funds held NAVs exceeding 20% of committed capital, with some venture capital (VC) funds surpassing 60%, according to an MSCI blog. This trend reflects a structural shift: funds remain active for 15–16 years, far exceeding traditional 10-year horizons, while distribution rates have consistently fallen below 50% since 2018, as MSCI noted.

The root cause lies in a "zombie exit freeze." The ratio of private equity investments to exits reached 3.14 times in 2025, the highest in a decade, according to a CNBC report. For every company sold, firms invest in three new ones, extending timelines and locking capital. High interest rates, weak IPO markets, and valuation gaps between buyers and sellers exacerbate the problem, as CNBC reported.

Systemic Impacts on Fund Performance and LP Returns

The persistence of zombie companies and funds directly undermines key performance metrics. Internal rate of return (IRR) and multiple on invested capital (MOIC) suffer as realizations are delayed and capital remains illiquid. For example, older buyout funds with 25% NAVs and VC funds with 30% NAVs distribute less than historical peers, according to MSCI. Traditional cash-flow models, such as the Takahashi-Alexander (TA) model, overpredict distributions, leading to misaligned expectations, as MSCI noted.

LPs face compounding challenges. Nearly half are exposed to zombie funds that collect fees but offer little return, CNBC reported. Smaller and mid-market firms, reliant on exits for cash flow, are particularly vulnerable, CNBC added. The result is a "zombie fund" ecosystem where capital is trapped, returns are deferred, and systemic risks accumulate.

Broader Systemic Risks and Regulatory Responses

The crisis extends beyond fund-level performance. Zombie companies, often over-leveraged, contribute to a "zombification" of the corporate landscape, reducing investment in innovation and infrastructure, according to a CFI Institute blog. This weakens economic dynamism and amplifies fragility during downturns. Meanwhile, zombie funds' interconnectedness with traditional financial institutions raises contagion risks. Private credit's expansion into corporate finance, for instance, has created opaque linkages that regulators struggle to monitor, as Harvard's MRCBG noted.

Regulatory responses are emerging but remain fragmented. Continuation funds-vehicles that transfer assets to new funds without liquidation-are gaining traction as a liquidity solution, CNBC reported. However, LPs increasingly resist extended timelines, opting for secondary market sales to recoup capital, CNBC noted. Central banks and regulators are urged to expand oversight of private credit, improve transparency, and address leverage and liquidity mismatches, as Harvard's MRCBG noted.

Conclusion

Private equity's zombie company crisis is a symptom of broader structural imbalances: liquidity constraints, valuation disconnects, and a shift toward long-term capital deployment. While the industry adapts with tools like continuation funds and AI-driven cost-cutting, these measures address symptoms rather than root causes. For LPs, the path forward requires rethinking performance metrics, enhancing transparency, and advocating for regulatory frameworks that align with evolving market realities. Without such reforms, the systemic risks of zombie entities will continue to erode trust and distort capital allocation.