This is a summary of "Do Private Equity Funds Manipulate Reported Returns?," by Gregory W. Brown, Oleg R. Gredil, and Steven N. Kaplan, published in the Journal of Financial Economics.
General partners (GPs) in private equity funds have the ability and motivation to manipulate the net asset value (NAV) of the fund, which investors rely on to make investment decisions. The authors find that some GPs do overestimate reported NAVs to entice investors but also that investors pay close attention to such manipulation.
What Is the Investment Issue?
Private equity investments are largely illiquid and not easy to value. A private equity fund is funded by investors—that is, limited partners (LPs). The LPs are at a disadvantage when valuing prospective investments because of the unique nature of investments made by private equity funds. The performance of such illiquid and heterogenous portfolios is evaluated based on the reported net asset value (NAV), which in turn is influenced by the data/valuation choices made by general partners (GPs).
Although the NAV is established by outside valuation consultants and auditors, it is a subjective process based on data from the portfolio companies that are directly owned/influenced by the funds/GPs. Thus, GPs have the ability and motivation to manipulate the NAV because investors rely on it to make investment decisions. GPs may overestimate reported NAVs to make the fund look attractive and entice investors. The authors’ findings suggest that institutional investors, however, pay close attention to such NAV manipulation.
How Did the Authors Conduct This Research?
The authors use a combined dataset obtained from Burgiss and from StepStone composed of 997 buyout funds with $25 million or more in committed capital and 1,074 venture funds with $10 million or more in committed capital. Of these, 641 buyout and 910 venture funds focus on North America; the rest are global funds. These funds represent around 200 institutional investors and a total asset base of around $750 billion in committed capital.
The Burgiss dataset is sourced exclusively from LPs and is supplemented with the information obtained from the StepStone SPI database (1971–2016). The former provides a complete and audited set of fund cash flows pieced together from the fund accounting information available to LPs.
Return manipulation is analyzed using a public market equivalent (PME) as a proxy to compute abnormal performance based on NAVs over a time period. To determine whether the fundraising performance predicts the final performance rank, the authors compute tercile transition probabilities over a given fund’s life. A linear probability model of a follow-on fund being raised is used to assess whether it is feasible to overstate interim returns. To identify peer chasing, future reported returns (based on cumulative past performance) are compared. To assess bias in the NAV, the authors use a ratio of reported NAV to an unbiased estimate of the market price of the fund’s assets (in an arm’s-length transaction, net of GP fees).
The data are also checked for cross-sectional differences and measurement errors with placebo tests and additional robustness checks.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors focus on analyzing trends in the NAVs reported by venture capital and buyout funds, discerning whether there is any distortion, and the reasons behind and effects of such exaggerations. Their theoretical framework is that GPs trade off short-term profits (by way of fees from an upcoming fund) with long-term consequences (success in a follow-on fund). GPs of top-performing funds tend to be more conservative and understate their returns to provide a buffer for unanticipated disadvantages and protect their reported NAVs from huge future variances. GPs of underperforming funds, however, are short-term oriented, and their concern for the firm’s survival outweighs the reputational concern. Therefore, they tend to inflate current NAVs in an attempt to bait investors for their upcoming fundraising. The performance rank during fundraising predicts the final performance rank. At the same time, the authors observe that rookie managers do not report NAVs more aggressively.
The authors examine whether returns are manipulated in pursuit of successful fundraising for a follow-up fund and find that valuation manipulation peaks during fundraising but subsides when fundraising concludes. The write-offs can increase because of GPs’ rationing effort between the newly raised fund and the old fund, but the abnormal returns continue to be positive, on average, for successful fundraisers.
Exaggerating the NAV is associated with a lower probability of raising a follow-on fund. Credible signaling (via distributing capital back to investors) is more important for sophisticated investors than the current performance rank, suggesting that investors are not fooled by this NAV manipulation.
There is also evidence of peer chasing, where top-performing GPs tend to be conservative and underperforming GPs tend to exaggerate returns. The adoption of the new Financial Accounting Standards (FAS 157, 2006–2008) has improved the quality and accuracy of NAVs reported by PE funds, but this analysis is complicated by the 2008–09 global financial crisis.