Investments in private equity are typically structured as 10 year limited partnerships in which fund managers act as general partners (GPs) and investors act as limited partners (LPs). Since the fund life is broken down into an investment and a liquidation period, GPs can only make new investments after the investment period has expired by raising a new fund. At that time, existing investments are not necessarily liquidated, so that current fund returns rely heavily on subjective performance estimates of their investments. This fact, stemming from a market setting of information asymmetries, has led many investors, industry observers, and academics to speculate that private equity firms distort their performance measurement around fundraising events. While this has been widely alleged, data limitations have made it difficult to draw sharp conclusions about this concern.
Various prior studies have focused on agency problems around fundraising, centering on the question of whether agents inflate portfolio values prior to fundraising. The common finding of these studies is that fundraising for a new fund coincides with times of high current interim valuations, especially for low-reputation funds, where cost of manipulation appears low (e.g., Barber and Yasuda 2017, Chakraborty and Ewens 2017 and Brown et al. 2017). This finding is open to two different interpretations. While GPs may advertise strong current fund performance by manipulating true estimates of current asset values as suggested by prior work, alternatively, GPs may time fundraising around true estimates of high current net asset values (NAVs).
Motivated by prior research, I argue that the data underlying these studies are aggregated too coarsely to attribute performance peaks to inflation of underlying asset values. To overcome data limitations of prior work, I have built a novel database of quarterly deal valuations in U.S. buyout funds that allows me to address the two hypotheses above.
What do we learn from deal level valuations about interim fund returns?
For a better understanding of why it is important to have data on individual portfolio companies, consider a fund with heterogeneous investment times. A peak of net asset values on the fund level, for instance, could be explained by inflated interim valuations of individual portfolio holdings. Alternatively, if deals made shortly before fundraising perform poorly so that their valuations after fundraising fall below their initial valuations at cost, these deals could reduce portfolio valuations after fundraising. If, in addition, deals made long before fundraising perform well, so that their initial valuations at cost increase around fundraising, the result would be a peak in aggregated values on the fund level just before a new fund is raised.
Indeed, I find strong evidence that funds with an especially low reputation have more successful investments well ahead of fundraising compared with deals made shortly before fundraising. Realized (or last observed) value multiples (VMs) of investments made long before the fundraising event exceed multiples of investments made shortly before the event, on average, by 130 percentage points. The difference stems from VMs of investments by low-reputation funds that were unrealized at the time of raising a new fund. I find no signs of systematically higher interim deal valuations.
Thus, the conjecture about manipulation is inconsistent with the deal-level evidence on fundraising. The finding of strong early deals increasing in value well ahead of fundraising, and weak later investments declining in value primarily after fundraising, is, instead, consistent with a timing of fundraising story.
Is fundraising timed to true performance estimates?
To test whether GPs are more likely to attempt to raise a new fund following estimates of truly good performance, I extend the results of Barber and Yasuda (2017). Their results suggest that NAV inflation predicts fundraising, and this effect is concentrated among those who most need to rely on interim NAVs as substitutes for reputation. By using hazard rate models, I find that fundraising is endogenously timed to true estimates of high current valuations, while their performance, especially in low-reputation funds, cannot be sustained in later deals. Consistent with this evidence, GPs appear to verify strong private performance with investments in publicly traded stocks (PIPEs or investments on the public stock exchange that are not taken private). I find that, on average, 10 percent of a private equity fund’s portfolio is not private equity but rather represents investments in publicly traded stocks that are not intended to be taken private. High positive returns in these public deals have a significant impact on the probability of fundraising. Backing NAVs of private portfolio companies with the verifiable performance of investments in publicly traded stocks appears to create less agency frictions than quickening of exits and “grandstanding” (Gompers 1996).
A remaining concern is that opportunistic investment behavior rather than timing of fundraising decisions explains my results. The idea here is that low-reputation funds may lack the network among private equity firms or sufficient deal flow and thus need more time than high-reputation funds do to find good investments. If GPs need more time finding good investments early on, they may face greater pressure to deploy unused capital (dry powder) towards the end of the contractual investment period and may pay a premium for deals later in the fund life. That said, I do not find any statistical or economic difference in dry powder between low- and high-reputation funds before fundraising.
Do strong returns around fundraising reflect skill or luck?
The question remains whether good deals with increasing valuations around fundraising reflect skill or luck. To address this question, I exploit the fact that the previously mentioned 10 percent stock investments of a private equity fund’s portfolio are accompanied by a Schedule 13D filing. My strategy of identifying investor skill is based on the market’s reaction to the announcement of the investor’s identity in the Schedule 13D. I find large positive average abnormal returns on the filing day of 2 percent for low-reputation funds and 4 percent for high-reputation ones. I also find that the positive returns at announcement are not reversed over time. If low-reputation funds were purely lucky in putting some early points on the board, the market should not react to their investments, or at least those abnormal returns should be later reversed. Under the assumption that private and public investments are expected to generate similar returns to justify both types of investments to LPs, this finding indicates that there is some level of skill involved when choosing investments.
Consistent with the timing hypothesis as opposed to strategic performance manipulation, GPs appear to time fundraising to true high-performance estimates of successful deals, while this performance cannot be systematically repeated in later deals. Concerns about strategic NAV manipulation by industry observers and investors seem to be unjustified. My results suggest that investors in a new fund might not earn as much as they expected but can expect to earn what they paid for.
Barber, B., and A. Yasuda, 2017, Interim Fund Performance and Fundraising in Private Equity, Journal of Financial Economics, 124, 172-194.
Brown, G., O. Gredil, and S. Kaplan, 2017, Do Private Equity Funds Game Returns?, Forthcoming in the Journal of Financial Economics.
Chakraborty, I., and M. Ewens, 2017, Managing Performance Signals Through Delay: Evidence From Venture Capital. Management Science Articles in Advance, 1-26.
Gompers, P. A., 1996, Grandstanding in the Venture Capital Industry, Journal of Financial Economics, 42, 133-56.
This post comes to us from Professor Niklas Huether at Indiana University’s Kelley School of Business. It is based on his recent paper, “Raising Funds on Performance: Are Private Equity Returns Too Good to Be True?” available here.