LPs Can See Through Valuation Inflation

An old saying goes that if one person calls you a horse, you may or not be a horse. If two people call you a horse, buy a saddle.

Buyout firms may want to go saddle-shopping now that a second academic study published this year finds that they inflate valuations during fundraising. “Some GPs of poorly performing funds appear to game returns in a last ditch effort to raise a follow-on fund,” the authors wrote.

The second paper, “Do Private Equity Funds Game Returns?”, makes two related and significant observations. One is that it is mainly firms that are ultimately unsuccessful in raising another fund that inflate valuations during fundraising. This “suggests that investors see through the manipulation,” the authors wrote. Second, firms with the strongest track records actually “underreport” their performance, “insuring against future bad luck that could make them appear as though they are NAV manipulators,” according to the paper.

The authors of the paper, dated May 29 and posted on the Social Science Research Network, are Gregory W. Brown, professor at Kenan-Flagler Business School at the University of North Carolina at Chapel Hill; Oleg R. Gredil, a PhD student at the same school; and Steven N. Kaplan, professor at the Booth School of Business at the University of Chicago.

A February paper posted on the Social Science Research Network by three other academics, including Tim Jenkinson, professor at the SaÏd Business School at the University of Oxford, found that venture capital and buyout firms are generally conservative in their valuations. Interim valuations, they found, on average understate subsequent realized values by 35 percent. However, they found an “exception to this general conservatism”—and that is when firms are in the market raising money. The authors based their study on 761 funds backed by the California Public Employees’ Retirement System.

The May paper studies a broader sample gathered from limited partners by data provider Burgiss Group. The sample includes some 997 buyout funds and 1,074 venture capital funds that are U.S.-dollar denominated; the buyout funds had to be at least $25 million in size to be included, the venture capital funds $10 million.