At a time of increased regulatory scrutiny over GPs' valuation estimates, 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 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 Oxford 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
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.”
This story originally appeared on privateequityinternational.com