Shenanigans

This Month’s edition of The Nord comes to you from the Warren E. Burger Federal Building in St. Paul, Minnesota.? No, I have not run afoul of the Feds.? I am here with 64 others to perform an important role in the proper functioning of our democracy, by ensuring defendants have a pool of their peers from which to select a jury.? Put succinctly, I got jury duty.

If selected, I will spend a few days listening to legal teams put forth their cases.? Both teams will present evidence in a way that paint their client in the best light, but do so within the bounds of the law, with a judge to keep them in line. It will then be up to me and other jurors to see through these legal shenanigans and do our best to evaluate the evidence as objectively as possible.

A private markets research analyst is put in a similar position when vetting fund managers. General Partners (“GPs”) will do what they can, within regulatory bounds, to present their firm and track record in the best light possible. GPs may engage in a range of shenanigans, some pushing ethical and regulatory boundaries (evil shenanigans).? Others, as I noted in last Month’s letter, are likely to “massage cash flows to their benefit” to improve their IRR (cheeky and fun shenanigans).? Let’s discuss a few examples.

Lift

As public equity markets dropped throughout early 2023, there was a growing debate as to the “true value” of private market companies, which had not seen an equivalent fall in value.? Several prominent hedge fund professionals cried foul, branding the private equity approach to portfolio company valuation “volatility laundering”. ?More recently, as equity markets returned to record highs, and private market valuations remained stable, the focus has shifted to private credit fund valuations, where it is claimed valuations are not reflecting the rise in interest rates and deterioration of credit quality that has punished public debt securities.

For now, let’s focus on private equity.? Do GPs consistently overvalue their portfolio companies?? On the first episode of the Capital Decanted Podcast, at about the 52 minute mark, Andrea Auerbach of Cambridge Associates talks about the Firm’s research into what it has dubbed “Lift”. ??To measure Lift, Cambridge compares the value a company achieved at exit, in an arm’s length transaction, to the value the fund had carried that same company 6 months prior.? Based on their research, they find that, on average, there is a positive lift in the valuation over those 6 months.? This would bolster the case that managers are more likely to be conservative when marking valuations upward, preferring to avoid disappointing LPs by eventually selling the company at a lower value.?

Based on this analysis, it does not appear that the private equity managers are consistently carrying values at an artificially high level over the life of an investment.? That said, are there times when it is more likely a GP may do so?

Valuation Management During Fundraising

?While Cambridge and others have addressed the holding values near the time of exit, one might ask whether there are other times in a fund life cycle that a GP might be more likely to nudge valuations upward.? Brian Baik addresses that question in his Harvard dissertation titled “Private Equity Fund Valuation Management During Fundraising”.? I would encourage you to read the paper in its entirety, but here is an excerpt from the abstract:

?“I investigate whether and how private equity fund managers (GPs) inflate their interim fund valuations (net asset values, or NAVs) during fundraising periods. Specifically, I study the extent to which the GPs inflate NAVs by managing valuation assumptions (e.g., valuation multiples), influencing the financial metrics (e.g., EBITDA and sales) reported by the private firms in their portfolios, or both. Using a sample of buyout funds and their portfolio firms in Europe, I find that funds managed by low reputation GPs show more dramatic forms of NAV inflation by managing upward not only valuation multiples but also portfolio firm earnings.”

It would appear, based on Baik’s work, that some GPs, particularly lower-performing ones, inflate valuations by manipulating certain accounting metrics and/or multiple assumptions.? Worse yet, he finds that managers engaging in this behavior are more likely to have success in subsequent fundraises, providing an incentive to do so.? Last month, I noted that the paper titled “Has Persistence Persisted in Private Equity” found no persistence of manager returns when using information available at the time of fundraising.? This sort of manipulation could be another explanation as to why persistence seems to be disappearing.

Cash Flow Timing

Have you ever invested with a Fund manager with a habit of ensuring that capital calls always land on the first day of a calendar quarter?? This is just one example of IRR shenanigans that is perfectly legal.? That said, you should make sure you look out for it when analyzing returns.?

So, why would a manager do this?? Some managers and LPs will aggregate cash flow activity by quarter and assign it all to the quarter-end date when computing IRRs.? The resulting difference between the treatment of a late-June vs. early-July capital, for example, can make a material difference early in the life of a fund.

Here is an illustration:

Farva Fund II and Thorny Fund II are both 2019 vintage private equity Funds.? Both managers have made 3 capital calls over a three-year period at approximately the same time.? Both funds are currently marked at a 2.0x TVPI and have had the same pace of NAV growth over time.? The only real difference is that Farva Fund II made capital calls on the first day of a calendar quarter every time, while Thorny Fund II made its capital calls 10 days before the end of the calendar quarter, 11 days before Farva Fund II.

If you are thinking, 11 days shouldn’t matter that much, you are right.? If you calculate the IRR of both funds over time using the exact dates of the capital calls in your XIRR function, the difference is less than 20 basis points at year ending 2023.

But what if a different calculation methodology is used?? Perhaps instead of having the exact dates of the capital calls, Farva Fund II based its calculation from quarterly capital account statements, which aggregate any cashflow activity during a quarter, and assign it to a quarter-end date.? In this case, Farva Fund’s capital calls will be recognized as if they happened a full quarter later than Thorny Fund, because each happened in different calendar quarters, despite only being 11 days apart.

Now, based purely on calculation methodology difference, nearly five years into the funds’ terms, the IRR difference is nearly 190 basis points.? This is a more meaningful difference, but maybe not enough to really move the needle.? As more time elapses, all else equal, the difference will continue to narrow and become less material.?

So, what is the big deal?

?Let’s look at what the difference looks like around the time Thorny and Farva are likely raising capital for Fund III.?

Most PE Funds are back to market raising a subsequent fund around 3-4 years into the current fund’s life.? By ensuring capital calls land on the first day of a calendar quarter, Farva’s returns may look anywhere from 400 to 800 basis points better than Thorny.? Even if Farva does use actual dates for its return calculations in marketing materials, there is a good chance that some of its current LP investors may not be.? They may be using a performance calculation engine that is aggregating by quarter, giving the appearance of significantly better returns.

Snozzberries to Snozzberries

This is one example of why it is important to understand what calculation methodology is being used when evaluating private market funds.? There is value in vetting a fund manager’s track record, but you should do so using your own PME-based quantitative tool if possible.? Try to understand and account for differences in valuation methodology between GPs.? Try to look through GP shenanigans and ensure your comparison is apples to apples, or in this case, snozzberries to snozzberries.