Back to School: Timing, not manipulation, may be why GP fund valuations peak around fundraising

  • Indiana U. study ties rising valuations to market timing
  • Studies, SEC believe firms boost returns around fundraising
  • “It’s a simple timing-of-fundraising story”: Indiana’s Hüther

Limited partners and the SEC have long suspected that private equity firms goose portfolio-company valuations around the time they market new funds. A new study suggests the link between fundraising and valuations may have more to do with timing than anything else.

“The suspicion out there is clearly that NAVs are strategically or specifically manipulated,” Indiana University Assistant Professor of Finance Niklas Hüther told Buyouts. “I can find evidence that contradicts that. … It’s more a question of deal composition and timing.”

Meaning, rather than inflating portfolio-company valuations to bolster their case for marketing new funds, many GPs may choose to fundraise around the time their existing holdings are highly valued.

Numerous studies, including some of those Hüther cites, found that valuations tend to rise around the time they started to market new funds. Several recent papers published by researchers at the University of North Carolina, California Institute of Technology and University of Chicago have suggested GPs inflate returns, or limit the flow of negative information to LPs, around marketing.

The trend attracted regulators’ attention as well. Prior to becoming chief compliance officer at Kohlberg Kravis Roberts, former SEC Enforcement Division Chief Bruce Karpati said the regulator observed firms write up the value of their assets during fundraising.

“Because investors and potential investors often question the valuations of active holdings, managers may exaggerate the performance or quality of these holdings. This type of behavior highlights something that I’m sure many of you already know: that interim valuations do, in fact, matter,” Karpati said at a Private Equity International conference in 2015.

Hüther says that while those studies may demonstrate bad behavior on the part of certain GPs, “this implicit assumption ignores an alternative explanation.”

“My overall results show no evidence of inflated valuations on the deal level,” he wrote in the study, released last month. GPs are more likely to raise a new fund when the valuations of their portfolio companies are supported by the share prices of similar publicly traded companies, he said.

Hüther came to this conclusion by examining valuations of underlying portfolio companies, rather than fund-level performance. An anonymous LP, which Hüther cited as “one of the largest international LPs in the world,” provided a dataset that included companies in 136 funds raised between 1996 and 2010.

“Companies that they invested in way before a fund was raised — two years or longer — those tended to be the ones that were increasing in valuation right around when a fund was raised,” Hüther said. “It’s a simple timing of fundraising story.”

Action Item: To read Hüther’s study, visit https://bit.ly/2F3HO0Z

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