Study: GPs inflate valuations during fundraising

A University of Oxford analysis of CalPERS’ private equity portfolio has found that GPs inflate valuations of existing portfolio companies while marketing follow-on funds.

There is no such thing as too much due diligence.

A recent study from the University of Oxford has found that general partners tend to inflate valuations of their portfolio companies while marketing follow-on funds. 

The study, which was previously reported on by Fortune, 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,” according to the report. 

The study – authored by professor Tim Jenkinson and two researchers – also found internal rates of return presented during fundraising periods have “little power to predict ultimate returns”. 

We find that valuations of remaining portfolio companies, and therefore reported returns, are inflated during fundraising.

University of Oxford study

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. The final IRR of the first fund was “only slightly above” 10 percent. However extreme that may seem, “it is by no means an isolated case”.  

“Our results show that investors should be extremely wary of basing investment decisions on the returns of the current fund, especially when looking at reported IRRs,” according to the study. 

Although fund managers were found to inflate fund valuations while marketing follow-on funds, the propensity to aggressively value fund assets seems to fall off when firms are not on the market, the researchers found.

“Over the entire life of the fund we find evidence that fund valuations are conservative, and tend to be smoothed (relative to movements in public markets),” according to the study. “Valuations understate subsequent distributions by around 35 [percent] on average.”

Timing is everything

The study’s findings have come at an interesting time for the private equity industry, which has been beset by regulatory scrutiny since the passage of Dodd-Frank in the US and regulations in Europe like the Alternative Investment Fund Manager Directive. 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 around private equity and has been looking into issues like how GPs value assets.

“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 December speech to the Regulatory Compliance Association. “This initiative has brought attention to a practice that went undetected for many years.”

Earlier this week, Oppenheimer & Co. settled a case with the SEC, which had alleged the the firm misled investors

This initiative has brought attention to a practice that went undetected for years.

Bruce Kaparti, SEC

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. Oppenheimer will pay an additional penalty of $132,421 to the Commonwealth of Massachusetts in a related action taken by the Massachusetts Attorney General.

On Wednesday, Representative Robert Hurt introduced legislation that would exempt private equity firms from registration requirements, claiming that registration inhibits firms from investing in small businesses. A similar version of the bill introduced in 2011 failed to make it through Congress. 

“In order for our economy to grow and for our small business owners and family farmers to be able to create the jobs that we need, we must remove unnecessary regulations that tie up private capital and create economic uncertainty,” Hurt said in a statement.