Can You Trust Private-Equity Returns? In the best of times, the true value of a private-equity fund is a mystery. At other times, the value might be manipulated to entice prospective investors

June 7, 2013, 6:26 p.m. ET

Can You Trust Private-Equity Returns?

By JOE LIGHT

In the best of times, the true value of a private-equity fund is a mystery. At other times, the value might be manipulated to entice prospective investors, according to new research. Private-equity funds are partnerships that own companies or other assets that aren’t typically traded on a public exchange. Before selling fund holdings, private-equity firms have to rely on recent sales of similar companies and other variables to guess at what the assets are worth. When the sales do happen, some research has found, private-equity-fund performance can be quite good. But in the meantime, it turns out that some firms might be using the ambiguity to make their returns look better than they really are, right before trying to raise capital for a new fund, according to recent research.Other, more commonly held investments, including mutual funds, also sometimes use hazy estimates of private-asset values. Some of the same cautions that apply to private-equity returns could apply to these investments as well, say experts.

That makes it important for investors to treat such valuations as rough estimates and, when they can, do their own research, says David Spaulding, chief executive of the Spaulding Group, a consulting firm in Somerset, N.J., that specializes in performance measurement.

“Any illiquid asset is at risk of less-than-accurate pricing,” he says. “Eventually, somebody’s going to have to sell that asset and the mispricing is going to come out.”

Attracting Investors

In the interim, private-equity firms have an incentive to make returns look good on paper so they can attract investors into their new funds.

Private-equity firms—which have raised $158.7 billion this year through Monday, according to industry tracker Preqin—are audited and increasingly hire consultants to help them value their holdings. Those third parties perform their own analyses but have to rely somewhat on what the firms tell them.

In the process, some private-equity firms appear to juice the returns intentionally to help raise new funds, according to research released in May by Greg Brown and Oleg Gredil of the University of North Carolina at Chapel Hill and Steven Kaplan of the University of Chicago.

“Some funds may be trying to convince people that they are better than they really are,” Mr. Brown says.

The good news: According to the research, most firms that try to manipulate their performance fail to raise a new fund. That suggests potential investors see through the trick.

The research estimates that those firms inflate their asset values by about 20% before trying to find new investors. Afterward, the estimated values typically fall back to earth. The paper finds that top-performing funds actually tend to underreport returns.

Another paper released in February by researchers at the University of Oxford in England also found that some private-equity funds seem to increase the value of their assets shortly before raising money.

In a statement, Bronwyn Bailey, vice president of research at the Private Equity Growth Capital Council, an industry group, said: “The [Brown] paper clearly demonstrates that private-equity returns are, if anything, being reported conservatively and that investors will not invest in firms that deviate from industry-accepted valuation practices,” adding that firms that can’t raise new funds will go out of business.

Moves to Make

So what is an investor to do?

For one, if you are a high-net-worth investor considering a private-equity fund, sign on only with firms whose funds have investments from major institutions, Mr. Brown says. Institutional investors do their own analyses of valuation methods to make sure a firm isn’t juicing its returns, which small investors can piggyback on, he says.

University of Oxford finance professor Tim Jenkinson, one of the authors of the February research, says investors might be best served by ignoring interim returns reported in marketing materials altogether. His research found that such returns have little correlation to the funds’ final performance relative to other funds.

Investors who hold mutual funds, closed-end funds and exchange-traded funds that invest in private companies or illiquid assets also should be wary of discrepancies.

For example, at the end of March, GSV Capital, GSVC +0.63% a closed-end fund that invests in private companies, had a net asset value of $12.69 a share, according to the company. At the same time, investors could buy the fund at $8.26, a 35% discount.

The problem is, few investors agree on the true values of the companies GSV owns.

Take the case of Twitter. The social-networking firm isn’t publicly traded yet, but that hasn’t stopped several mutual funds from picking up shares. GSV Capital owned about 1.8 million shares at the end of March, the latest data available. Another fund, T. Rowe Price New Horizons, owned 4.6 million shares at that time.

But while GSV Capital said the shares were worth $18.53 apiece, T. Rowe said the shares were worth only $16.38.

Anyone buying GSV based on its discount could be in for a surprise if Twitter goes public close to the lower price. GSV Capital Chief Investment Officer Michael Moe says that the firm used information from a recent private sale of shares to help estimate its value. In a statement, T. Rowe Price Group TROW +2.28% said it uses “a wide variety of sources and information” to estimate the value of private companies.

To avoid such problems, investors should look in funds’ reports to see how the firms value assets, Mr. Spaulding says.

If market prices aren’t available, it is best for companies to use the values of comparable businesses to derive an estimate and least desirable for them to try to guess at the value by running their own valuation analyses, he says.

One day, when the investments go public or are sold, you will find out who is right. For now, it pays to be cautious.