A new paper by Oxford professors, “How Fair Are the Valuations of Private Equity Firms?”, presents the first long-term analysis of private equity funds to determine the extent to which interim valuations differ during the life of the fund—particularly when the PE firms are in the midst of raising a follow-up round of investment. By examining the quarterly valuations and cash flows for the entire history of 761 fund investments made by CalPERS (the largest U.S. investor in private equity), the Oxford authors came to three main conclusions:

• First, valuations are largely conservative over the entire life of the fund, with interim valuations understating subsequent distributions by an average of 35% but tending to rise in fourth-quarter reports (when funds are normally audited);
  
• Second, the exception to this general conservatism is when the fund managers are trying to raise another round of funds. During this marketing phase, valuations and reported returns are “inflated,” with a gradual reversal once the firm has closed its next round of funding; and
• Third, the “inflated” fundraising values have little power to predict ultimate returns, particularly when performance is measured by IRR.

The authors’ findings—which they reached by performing a regression analysis of 330 funds in the midst of raising new investment—are “clearly relevant to recent regulatory concerns about conflicts of interest facing private equity fund managers,” they say. “It is hard to rationalize the pattern we observe except as a positive bias in valuation during fundraising.” Although using public market equivalent measures increases the predictability of fund performance significantly, “the results show that investors should be extremely wary of basing investment decisions on the returns—especially IRRs—of the current fund.”

A growing niche for valuation analysts? “Subjectivity in private company valuations will always exist, especially when market forces change as rapidly as they often do for private equity portfolio companies,” comments Professor John Paglia (Pepperdine). “However, consistent overvaluations of current portfolio companies when raising new funds can lead to economic imbalances through misallocations of capital. If business appraisers position themselves properly, they can increase their numbers of engagements [in the PE arena] and contribute to solving the overvaluation problem.”