New Research Suggests Private Equity Firms More Likely To "Manipulate Performance" When Fundraising

Evaluating private equity funds and feel it’s all just too good to be true? You may be onto something. 

New research from the Journal of Corporate Finance shows that when private equity firms of all stripes (not just those that focus on commercial real estate) are feeling a fundraising pinch, they’re more likely to massage performance metrics for companies in their portfolios. The paper—written by scholars Ranko Jelic of the University of Sussex Business School, Dan Zhou of the University of Reading, and Wasim Ahmad from the University of Birmingham—shows that regardless of a firm’s reputation, PE firms may “manipulate their numbers” to give the appearance of better performance. 

“When prospective limited partners (LPs) evaluate the performance of a PE firm’s latest funds, they have to rely on valuations reported by PE firms,” the paper reads. “The link between PE firms’ fundraising and performance evaluation is thus an area susceptible to manipulation resulting in potentially high stakes.”

Compounding the problem: private investments are obviously not publicly traded, and so private equity firms report less frequently. Their valuation is also based on a model, the paper notes, not market transactions and conditions, and is thus often delayed— leading to potential incentives for general partners “to engage in opportunistic behavior and exaggerate fund performance.”

This so-called “opportunistic behavior” also encompasses earnings management in portfolio companies exiting via IPOs that have the practical effect of inflating valuations and justifying NAV increases. Rising pressure to attract limited partners encourages general partners to “take shortcuts” like inflating reported fund performance, the paper concludes. Since GPs “lifetime compensation and career prospects” are directly related to expected income from subsequent funds, there’s motivation to “exaggerate their performance during fundraising campaigns.”

And then there’s the issue of fundraising frequency: it matters, according to the report’s authors.  The paper notes that typical PE fundraising processes last between a year and two years, and requires a lot of effort through time, money, and management attention. Smaller firms feel this pain more acutely, though the pressure is on for PE firms of all kinds, and they may thus attempt to raise funds more frequently to “establish their reputation.”

“The main contribution of the paper is new evidence on the opportunistic behavior and conflicts of interest between GPs and LPs,” the report states. “Our findings lend support to the view that the agency conflicts exist, and that GPs’ opportunistic behavior extends to portfolio companies, despite sophisticated PE contracts.”