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.”