Private Equity Firms May Inflate Returns, Claims Research

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Private equity firms now manage hundreds of billions of dollars of public pension money, in part because the asset class advertises its ability to deliver strong returns without the volatility of the stock market.

Due to the illiquid nature of private equity, the industry’s return figures are often estimates – a valuation of what the firm’s investment would have sold for, had it been sold.

But new research from George Washington University suggests that private equity firms inflate the on-paper value of their investments.

More details from the International Business Times, which received an advanced look at the soon-to-be-released research:

Now comes new data from [investment banker Jeffrey] Hooke and George Washington University’s Ted Barnhill and Binzi Shu that purports to prove mathematically that the private equity industry’s books are misleading.

The researchers essentially created a portfolio of publicly traded companies that they say closely resembles the kinds of privately owned companies that private equity investors buy. The researchers then weighted their public companies’ returns to reflect the same level of debt that private equity firms typically impose on their portfolio companies.

The researchers argue that their index of public companies should show roughly the same returns as the private equity industry. “All things being equal, an auto parts company that is publicly traded will have the same value as an identical auto parts company that is privately owned,” Hooke, who is an executive at Focus Investment Banking, said.

Instead, though, the private equity industry’s stated returns were noticeably less volatile than the publicly traded companies’ returns. The researchers assert that the private equity industry uses its latitude to self-value its own portfolios in order to make their returns look “smoother” than they actually are. “Investors may have been unfairly induced into placing monies into these investment vehicles,” they conclude.

The CalPERS website says “there are no generally accepted standards, practices or policies for reporting private equity valuations.”

The SEC has taken notice, as well:

At the Securities and Exchange Commission, a top enforcement official in 2013 declared that the private equity companies that the agency had been scrutinizing were “exaggerat(ing)” the reported values of their portfolios. That declaration followed the release of studies by academic researchers finding evidence that valuations were being manipulated. The SEC subsequently reported that it found “violations of law or material weaknesses in controls” at more than half of the private equity firms that the agency investigated.

Read the full IBT report here.


Photo by Roland O’Daniel via Flickr CC License

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