Seeing the whole picture
New research reveals that the narrative tone of interim reporting can be a better predictor of future performance than financial metrics alone.
By Amy Carroll
Private equity’s illiquidity and long-term nature present investors with a conundrum when deciding whether or not to commit to a new fund: how do they assess the probable future performance of a portfolio that is largely unrealised? And, by extension, how accurate are the interim valuations that the general partner provides during fundraising?
This issue is particularly pertinent today, as exits have proved hard to come by in recent times. “The predecessor vehicle’s portfolio is the basis of the due diligence that we do to determine the quality of the manager,” says Sven Czermin, a partner at Palladio Partners. “Fundraising cycles come around every three or four years, while holding periods at the moment are often at least five or six years. So, when we are assessing a fund, we are largely trying to evaluate the performance of unrealised investments.”
Our research adds to a body of academic literature that highlights the limitations of interim valuations.
Florencio Lopez-de-Silanes, SKEMA Business School
Investors therefore have to look closely at a GP’s interim valuations – but they have to approach these with caution and a degree of scepticism. “The reliability of interim valuations as predictors of final performance is moderate and conditional,” says David Scopelliti, global head of private equity and private debt at Mercer. “Interim valuations are often noisy and are subject to manager discretion, timing effects, and market sentiment.”
“In my opinion, interim valuations are not a reliable predictor of future performance,” adds Czermin. “Yes, there are guidelines, but GPs still have a certain degree of discretion when it comes to how these valuations are presented. They can use adjusted, budget or forecast EBITDA, or the last 12 months’ EBITDA. The same is true for multiples. They can keep them constant, look to public markets, and choose whether or not to use discounts. The true value can only really be determined at exit, so while interim valuations should provide a strong sense of where assets stand at a particular point in time, in reality, there is too much potential for upward bias.”
There has been extensive research examining the informational value of PE interim valuations, but there has been little analysis of the accompanying qualitative disclosures. This is a gap that Would I lie to you? On Private Equity Intermediary Performance Reports aims to fill.
The research was carried out by Borja Fernández Tamayo (Université Côte d’Azur, SKEMA Business School and Unigestion), Reiner Braun (Technische Universität München School of Management), Florencio Lopez-de-Silanes (Université Côte d’Azur, SKEMA Business School and the National Bureau of Economic Research), Ludovic Phalippou (University of Oxford, Saïd Business School), and Natalia
Sigrist (Unigestion). It draws on a novel dataset of over more than 20,000 interim performance reports from 2,049 investments, including both quantitative metrics such as sales, EBITDA margins, and valuation multiples, and over 240,000 sentences of qualitative commentary, to provide richer insights into portfolio dynamics. The project was developed in partnership with Unigestion, the source of the raw data used, and SKEMA Business School, which provided funding.
Using LLMs, the research finds that the tone of the commentary included in interim performance reports is a reliable predictor of how investment performance could change from interim to final valuation. A positive tone is associated with a significantly higher realised multiple on invested capital (MOIC), even after controlling for an investment’s interim valuation and fund characteristics.
Specifically, it finds that a one standard-deviation increase in measured optimism (equivalent to a change from a neutral tone to the average — moderately positive — tone) results in a 0.18x subsequent increase in MOIC. The same magnitude of increase in interim MOIC results in just a 0.09x subsequent increase in MOIC above the interim. Reporting tone is particularly informative during fundraising periods and, unlike interim valuations, tone consistently predicts final multiples across GP locations and deal regions.
