Some Private-Equity Funds Game Returns, but Lose Anyway

By their nature, private-equity funds hold assets that are hard to value. Thus it can be easy, and perhaps even tempting, for managers to overstate asset values. In recent years, the US Securities and Exchange Commission has begun investigating private-equity firms looking for evidence of insider trading and other infractions.

But research by Professor Steven Neil Kaplan, in collaboration with Gregory W. Brown and Oleg R. Gredil of the University of North Carolina at Chapel Hill, suggests that investors are already on the case—and successfully sniffing out gaming.

In an extensive survey of investment programs, Kaplan, Brown, and Gredil observe that during periods when private-equity firms were marketing new funds to prospective investors, some firms’ existing funds reported abnormally high returns.

They had incentive to make the returns look good. When determining where to put their cash, potential investors don’t know how managers will use any money they commit to a new fund. Moreover, many of those investments will probably be privately held and largely illiquid. So investors rely on limited information, including the reputation of a fund’s manager and reported values of that manager’s previous funds.

Unfortunately for fund managers, many investors also rely on the moves of leading institutional investors. If institutional investors determine that management manipulated reported returns on a fund, those institutional investors will not commit to a new fund from the same management team, and neither will other investors following their lead. This could leave a private-equity firm without investors for a new fund.

“Little manipulation of net asset values goes unnoticed by institutional investors,” the researchers write. “They [investors] appear to punish managers for what looks like dishonest interim reporting.” They also write that this manipulation “appears to be limited to a subset of underperforming funds.”

Many situations can persuade managers to game their returns. The researchers find that manipulation is more likely to happen when fewer new funds are looking for investors, because the benefit of manipulation has a greater potential to positively impact fundraising.

Also, managers appear to be motivated by peer pressure, as they keep track of the performance of competitor funds of similar ages and strategies. And the researchers find strong evidence that managers of poorly performing funds will overstate returns in order to attract investors to a new project—after all, if the current fund is a disaster, there will be no follow-on fund.

The authors find that, thanks to reputational concerns, managers at the best-performing private-equity funds don’t game returns and are in fact conservative in their reporting. They tend to understate returns to build in some insurance against problems that could later be misconstrued by investors as manipulation.

Kaplan, Brown, and Gredil use a dataset of 220 investment programs accounting for more than $1 trillion in capital, provided by Burgiss, a private-equity software and solutions provider. The data come from investors: 60% pension funds, 20% endowment or foundation funds, and the rest a mix of other institutional investments. The researchers examine patterns in fund returns since their starts and around fundraising events, while also tracking the establishment of follow-on funds.