Interim performance influences size, timing of next fund, study shows

The paper also reinforces recent research suggesting that some sponsors may artificially inflate the valuation of their portfolio companies while marketing their funds—a phenomenon that could land the industry in hot water with regulators.

According to the paper, which studied the cash flows and valuation data of more than 800 buyout and venture capital funds raised from 1993 to 2009, ”the current fund’s most recent percentile rank (relative to its vintage-year cohort funds) has a positive and economically significant effect on the GP’s probability of successfully raising a follow-on fund and on the size of the fund raised.” The authors found the same correlation for both buyout and venture capital firms. For emerging managers and sponsors of small funds they found the correlation to be even stronger.

The paper, dated November 18 and titled “Interim Fund Performance and Fundraising in Private Equity,” is co-authored by colleagues at the Graduate School of Management at the University of California, Davis—Professor Brad M. Barber and Associate Professor Ayako Yasuda. They used data provided by Preqin.

Given the obvious incentive sponsors have to demonstrate strong performance while marketing a fund, the authors hypothesized—and indeed found—that sponsors time their fundraises for periods when their most recent fund’s interim performance peaks. Wrote the authors: “For buyout fundraisers, the performance of the current fund peaks three quarters prior to the conclusion of fundraising; for VC funds, the peak performance is observed at the conclusion of fundraising.”

At the same time, the authors found that emerging managers and sponsors of small funds mark down the net asset values of their portfolios so significantly in the wake of fundraising that it suggests they may be inflating their NAVs during fundraising. They did not find this to be the case among older, more established firms. However, the paper notes that ”the erosion in fundraisers’ performance ranks might also naturally occur as a result of mean reversion…”

The issue of possible valuation inflation during fundraisings has become an important one for the industry to address, according to the paper. Speaking in early 2013 at the Private Equity International Conference in New York City, Bruce Karpati, then chief of the U.S. Securities and Exchange Commission enforcement division’s asset management unit, said: “One type of manager misconduct we’ve observed involves writing up assets during a fundraising period and then writing them down soon after the fundraising period closes.”