Study: Struggling GPs inflate valuations

General partners of poorly performing funds are prone to gaming returns in a last ditch effort to raise a follow-on fund, but investors often see through their manipulation, concluded a team of researchers from the University of North Carolina and University of Chicago.  

The study comes at a time when the US Securities and Exchange Commission has made performance numbers a priority when inspecting private equity firms. In March the agency charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a private equity fund they manage. 

The findings follow University of Oxford research that found evidence GPs tend to inflate valuations of their portfolio companies while marketing follow-on funds. 

The new study however concludes that top-performing funds actually lowball their valuations, a strategy done to manage investors’ expectations about investments that may later sour. In contrast it is underperforming GPs – who have less to lose in terms of reputation if their numbers don’t hold up – that are prone to juicing their NAVs before launching a follow-on fund, the study concluded. 

 “…for underperforming GPs these long-term reputational concerns appear to be dominated by a short-term survival requirement to raise a next fund. Therefore, they are incentivized to boost to-date results to the extent the gap is not too large,” said the study’s authors. 

The study also inferred that sophisticated private equity investors are not fooled by GPs who game their numbers. Funds that report a promising NAV but fail to deliver when investments are realized have difficulty raising a follow-on fund, the study said. 

“Thus, this evidence is suggestive of attempts at manipulation that are not successful since investors are not willing to commit to a next fund.” 

The study examined roughly 1,800 funds of more than 200 institutional investors with data supplied by the Burgiss Group.