Here’s More Evidence That Private Equity Managers ‘Inflate’ Fund Values When Raising Money

Low-reputation managers wouldn’t be able to attract investors without manipulating their multiples and earnings, according to research from Harvard.

II, Inkdrop/Bigstock

II, Inkdrop/Bigstock

To keep up with high-performing fund managers, private equity firms with lesser reputations inflate their funds’ value during fundraising periods.

Previous research has found abnormally high private equity fund valuations during fundraising periods, leading researchers to debate whether or not firms manipulate these figures or raise money during the best performing periods. In a paper titled “Private Equity Fund Valuation Management During Fundraising,” Brian Baik, an assistant professor at Harvard Business School, looks for evidence of manipulation by studying the extent to which firms inflate net asset values by managing the assumptions behind valuation, including the multiples used, or influencing earnings and sales of underlying companies in their portfolios.

He found that private equity fund managers with less-than-stellar reputations overstate the values of their funds during fundraising. Baik adds insight on a firm’s reputation to the body of research on private equity.

“I examine the components of the NAVs and provide evidence that funds managed by low reputation GPs show inflated valuation multiples and inflated financial performance of their investments during fundraising, which is consistent with the manipulation hypothesis,” according to the paper.

Baik looked at the NAVs of funds, and how they were calculated, during fundraising periods. Net asset values are simply the sum of the value of each portfolio company held in the fund, but the calculations rely on complex assumptions.

Because most of these investments are private companies that don’t have publicly available market prices, private equity firms can use different valuation techniques to determine the value of the fund. According to the paper, private equity firms most often apply multiples to their portfolio firm earnings, usually in the form of EBITDA [earnings before interest, taxes, depreciation, and amortization] or sales.


Private equity firms can then apply higher multiples or “manage the earnings of their investments” to appear more valuable than they really are to investors during fundraising periods. To manage the earnings of their investments, firms use a legal accounting concept called earnings management, which means managers can accelerate the recognition of revenue or delay some expenses so they can report higher earnings.

Baik predicted that firms use either high multiples or inflated portfolio company earnings — or both — to inflate their NAVs during fundraising periods. To test his hypothesis, Baik separated his sample set into low-reputation and high-reputation managers. Generally, Baik defined a low-reputation fund manager as one with a history of poorer performance, fewer funds, and a smaller asset base.

For all of the firms in the sample, Baik first tested if multiples increased during fundraising. Then he investigated whether portfolio company earnings shot up during the same periods.

According to the report, funds with low reputation managers showed an increase in valuation multiples right before fundraising periods closed. These same multiples exhibited “sharp reversals” in the post-fundraising period, the report said. Baik also found that low-reputation firms increase their portfolio company earnings during fundraising periods.

Baik said managers that didn’t have great reputations have come to rely on these manipulation tactics for investor support. Without them, investors wouldn’t allocate their capital to these managers.

“Without any manipulation, their valuations are going to be so low that when a potential LP comes in to examine these funds…the LPs wouldn’t think about investing in this fund at all,” Baik told Institutional Investor.

If low-reputation private equity firms are able to manage or manipulate these multiples or valuations up to a point that is competitive with high-reputation managers, they might have a chance of raising a successful subsequent fund, Baik said.

“Because the base probability of raising another fund for these low-reputation GPs is so low, they’re almost forced to manipulate these valuations,” he added.

Baik’s findings add a new layer to a growing line of similar research, including a 2019 paper from professors at Carnegie Mellon’s Tepper School of Business, which found that taking out a loan instead of taking money from investors boosts a PE fund’s IRR by 6.1 percent. However, the authors argued that this performance bump is, in fact, a distortion, II previously reported.

Similar studies have found that private equity firms inflate NAVs during fundraising and hide bad news from investors when fundraising is slow. Last year, one paper from scholars at the University of Sussex, University of Reading, and the University of Birmingham found that private equity firms under pressure to fundraise manipulated their numbers to show strong performance regardless of the reputation of the manager. Here, the misrepresentation is a result of the managers feeling mounting pressure to relay strong valuation figures to investors, II previously reported.

This issue isn’t specific to just private equity. Venture capital firms also feel the heat to fundraise, and, as a result, tend to misrepresent deal values to inflate their interim returns.

For investors hoping to avoid these low-reputation firms, Baik said it’s important to examine the underlying components of valuations and to look at the individual financial statements of portfolio firms. In short, conduct due diligence at every level.