Are private equity firms window-dressing at fund-raising time?

Recently, “more and more doubts have arisen as to whether building special-purpose vehicles as closed-end limited partnerships as a form of intermediation to gather funds to invest equity in private companies is the right form of governance,” write the authors of a January paper, “The Limited Partnership Model in Private Equity: Deal Returns over a Fund’s Life.” The paper is co-authored by Reiner Braun, a professor at Friedrich-Alexander University at Erlangen-Nuremberg, and Maximilian Schmidt, a doctoral student at the Technische Universität München at Munich. 

Studying more than 10,000 realized investments exited by some 702 mature funds over more than 30 years—a dataset supplied by three managers of funds of funds—the authors find that for both venture capital and buyout fund returns on individual deals “vary strongly” over the life of a fund. “More specifically, we provide robust evidence that returns to investments realized when a new limited partnership is raised are significantly higher than for investments exited after such a new fund is closed.” Indeed, the authors find a striking pattern of sponsors scoring a few home runs within two or three years of a fund’s launch; exiting in years four and five an “increasing number” of deals with “poor returns,” followed by a final period of exits producing middling returns.

Damningly, the authors write: ”We relate this finding to potential window-dressing behavior of PE fund managers.” However, they find such window-dressing “much more pronounced” for the venture funds that they studied, compared to the buyout funds—possibly because of the greater difficulty venture firms have had raising money since the Internet bubble of the late 1990s. “We conclude that in VC, as a major part of the PE asset class, limited partnerships in their current form are not suitable to align the interests of GPs and LPs.”