Private equity’s fundraising spin

March 14, 2013, 10:17 PM UTC

FORTUNE — Private equity firms inflate performance data when trying to raise new funds, according to University of Oxford researchers. That sound you hear is the limited partner community shouting “I knew it!”

The study examined 761 funds that received investments from the California Public Employees’ Retirement System (CalPERS) since 1990, including funds that focused on buyouts, growth equity and venture capital. CalPERS publicly reports top-line performance data each quarter, but the researchers also gained access to time-series numbers of capital calls, capital distributions and remaining portfolio NAV.

What they found was that fund managers tend to value their portfolios conservatively, with interim valuations that understate subsequent distributions by an average of 35%. They also saw the fund valuations tended to rise in Q4, suggesting that firms often waited until year-end audits to mark up their investments (albeit still well below ultimately sale prices, on average).

So far, so good. What comes next, however, is disturbing:

“The exception to this general conservatism is the period when follow-on funds are being raised. We find that valuations of remaining portfolio companies, and therefore reported returns, are inflated during fundraising, with a gradual reversal once the follow-on fund has been closed. This finding is clearly relevant to recent regulatory concerns about conflicts of interest facing private equity fund managers… It is hard to rationalize the pattern we observe except as a positive bias in valuation during fundraising.”

The researchers made this conclusion after using regression analysis on a subset of 330 funds managed by firms that were known to be raising follow-on funds. Here is one egregious example, albeit without any identifying information:

Private equity valuation is a subjective science, despite the recent introduction of mark-to-market requirements. It would appear that many firms are abusing that subjectivity, in order to improve their ability to stay in business. Perhaps prospective investors should pay less attention to current valuations during fundraising, and more to valuations that actually are a couple of years out of date…

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