Do Stressed PE Firms Misbehave?

Abstract

For private equity (PE) firms, follow-on funds provide additional streams of management fees for a considerable time. When prospective limited partners (LPs) evaluate the performance of a PE firm’s latest funds, they have to rely on valuations reported by PE firms. The link between PE firms’ fundraising and performance evaluation is thus an area susceptible to manipulation resulting in potentially high stakes. We examine the relationship between PE firms’ fundraising pressure and earnings management in portfolio companies, along with heterogeneity in behaviour by reputation and dry powder. To proxy for the degree of fundraising pressure, we develop an index based on PE firms’ affiliations, stage in the fundraising cycle, and fundraising frequency. Results suggest that the fundraising pressure leads to more earnings management in portfolio companies, regardless of PE firm reputation. While the reputational effect remains unchanged under a change in funding pressure, dry powder exhibits a strong moderating effect under extreme funding pressure. The results are robust to alternative proxies for earnings management, alternative fundraising indexes, and various controls for endogeneity concerns.

Keywords: private equity, fundraising, earnings management, IPOs

JEL Classification: G24, G34, M41