PERFORMANCE AND VALUATION BIAS IN PRIVATE EQUITY

Abstract

This study looks at the possible existence of bias in private equity firms’ intermediate valuations of their funds. General partners may have an incentive to report higher valuations in order to keep their current limited partners satisfied, to generate higher investment advisory fees, or to help the fundraising process for new funds. The hypothesis is that private equity firms that engage in this kind of non-ethical behavior produce weaker returns. This paper uses the Preqin private equity database for 940 buyout funds and 1009 venture capital funds. The most recent fund valuations are regressed on the intermediate valuations, while controlling for fund characteristics and macroeconomic conditions. The results suggest that the intermediately reported net IRR is generally a good predictor of the final performance. There may be valuation bias because liquidated funds that show fully realized gains have weaker performance than closed funds that depend on unrealized value, which can be manipulated by the GP. This is also shown in the fact that valuations given after distributions have been made are more reliable. Valuations given during a recession are less reliable as predictors of final performance, which also suggests that the GPs may be skewing performance measures, especially during tough economic times when there are incentives to do so. This study also finds that performance is negatively correlated with the GDP growth rate and the S&P 500 return rate.