LPs Not Fooled by Inflated PE Valuations

Underperforming private equity firms often overstate portfolio values when launching new funds, a study has found—but investors don’t fall for it.

To any private equity firms thinking of exaggerating their performance to better raise a new fund: Don’t bother.

“Sophisticated LPs are, on average, unlikely to misallocate capital.”While portfolio net asset values (NAVs) are easy to distort due to their subjective nature, limited partners (LPs) are not easily tricked by valuation manipulations, according to a study by the National Bureau of Economic Research (NBER).

Underperforming managers often boosted reported returns when attempting to raise money for new funds, reported finance professors Gregory Brown, Oleg Gredil, and Steven Kaplan. However, these managers were unlikely to succeed in launching a new product.

“Investors see through much of the manipulation,” they wrote. “Overstating interim returns has not been a winning strategy for GPs on average.”

For the study, the NBER researchers used private equity transactional and valuation history for over 200 LPs from private capital data provider Burgiss. This information, combined with Stepstone’s SPI database of fund sequences and start dates, allowed the authors to determine when general partners (GPs) distorted NAVs—and how these distortions affected fundraising.

They found that exaggerated portfolio values were associated with lower probability of raising follow-up funds. Furthermore, conservative reporting had stronger positive effects on fundraising than market-adjusted performance.

In particular, top-performing GPs were shown to underreport NAVs in order to safeguard their reputation from negative shocks.

“GPs who are not underperforming should have an incentive to be truthful, or even conservative, with their unrealized investment valuations,” the authors wrote.

But whether GPs over- or understated performance, Brown, Oleg, and Kaplan found that LPs did not take interim performance reports at face value. Instead, investors appeared to prefer performance signals in the form of cash distributions following successful divestments by funds.

“Sophisticated LPs are, on average, unlikely to misallocate capital,” they concluded.

Read the full report, “Do Private Equity Funds Manipulate Reported Returns?

Related: Debunking Private Equity Performance