Are GPs cooking the books?

A new report suggests GPs are guilty of over-valuing portfolio companies during the fundraising process – and the US regulator is keen to do something about it.

Are some private equity managers guilty of overstating their case on the fundraising trail? A study published in March by the University of Oxford suggested that private equity fund managers tend to inflate valuations of their portfolio companies while marketing follow-on funds.

Authored by professor Tim Jenkinson and two researchers, the study examined the California Public Employees’ Retirement System’s portfolio of 761 private equity funds, going back to 1990.

“We find that valuations of remaining portfolio companies, and therefore reported returns, are inflated during fundraising, with a gradual reversal once the follow-on fund has been closed,” the report concluded.

One unnamed firm cited in the study’s introduction had valued its fund’s IRR at between 30 percent and 50 percent during the time it was on the market with a follow-on vehicle. However, the final IRR of the first fund was “only slightly above” 10 percent. And this is “by no means an isolated case”, according to the report.

We find that valuations of remaining portfolio companies, and therefore reported returns, are inflated during fundraising, with a gradual reversal once the follow-on fund has been closed.


“We have seen it sporadically, and that’s why we do lots of due diligence – you talk to other investors as well as board members and CEOs about the prospects for various companies,” says one North America-based fund of funds manager. “We don’t see that it’s a widespread problem, [but] it is an issue at times. And we do need to do additional due diligence to corroborate valuations during the fundraising period.”

The study also found that the propensity to aggressively value fund assets tends to fall off when firms are not on the fundraising trail.

“That analysis rings true, but it’s important to clarify that it is by no means a universal practice,” says another limited partner. “A lot of high-net-worth investors or family offices don’t do the same kind of due diligence that a pension fund or fund of funds manager would do. So if a big part of a fund’s market is those kinds of individuals and families, they’re more likely to inflate values.”

It’s a timely study, given that the private equity industry currently finds itself under increased regulatory scrutiny – particularly as a result of the Dodd-Frank act in the US and the Alternative Investment Fund Manager Directive in Europe.

Under Dodd-Frank, firms are now required to register as investment advisors with the US Securities and Exchange Commission, a legal distinction that mandates tighter reporting standards. As a result, the SEC has bolstered its investigative capabilities – particularly around asset valuation.

“This risk analytic initiative seeks to identify those private equity fund advisers that may be improperly failing to liquidate assets, or have been misrepresenting the value of their holdings to investors,” said SEC asset management enforcement chief Bruce Kaparti in a speech to the Regulatory Compliance Association last year. “This initiative has brought attention to a practice that went undetected for many years.”

Earlier this year, Oppenheimer and Company settled a case with the SEC which had alleged the firm misled investors about the performance of a private equity fund it managed. Oppenheimer agreed to pay a $617,579 penalty and return $2,269,098 to investors. The firm will pay an additional penalty of $132,421 to the Commonwealth of Massachusetts in a related action taken by the Massachusetts Attorney General.

Attempts to exempt the industry from these requirements have so far come to naught. So managers need to watch their step – because regulators are looking out keenly for the kind of sharp practices highlighted in the Oxford study.