How One Big Private-Equity Fund Makes Its Numbers Incomprehensible
It used to be that only the most sophisticated institutional investors wrestled with the opaque world of private equity valuations. Pension funds, endowments, and sovereign wealth funds, with their dedicated teams and deep pockets, were the primary players navigating these often-murky waters. But with the Department of Labor increasingly opening the door for 401(k) plans to dabble in alternative investments, what was once a niche concern is now a far broader public issue. Suddenly, the average American's retirement savings might, unknowingly, be exposed to investment vehicles whose performance metrics can feel less like clear financial statements and more like abstract art.
The core of the challenge lies in how private equity funds, unlike publicly traded companies, value their holdings. There's no daily stock price to look up; instead, assets are "marked-to-model," meaning the fund itself often determines the value of its investments. This isn't inherently nefarious, but it certainly opens the door for a variety of "tricks of the trade" that can make true performance incredibly difficult to discern. For example, consider a scenario where a fund acquires a struggling software company. Rather than valuing it based on immediate market comparables—which might be scarce or unflattering—they can use their own internal projections of future growth, cost synergies, and market expansion. These projections, while sometimes well-founded, are inherently subjective.
One common technique we observe is the strategic use of add-backs to adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). While a standard practice for private company valuations, some funds push the envelope, including highly speculative or non-recurring items as though they were fundamental to the business's ongoing profitability. Think about it: expenses for one-off restructuring consultants, or projected savings from a theoretical future acquisition that hasn't even happened. By painting a rosier picture of the underlying company's earnings power, the fund can justify a higher valuation for its own books, even if that value isn't truly reflected in the operational reality. And remember, a higher reported valuation directly impacts the management fees (typically 1.5-2% of assets under management) and, critically, the carried interest (the 20% share of profits) that the fund's general partners eventually earn.
What's more interesting is how a fund can leverage its own capital structure to obscure performance. We've seen instances where proceeds from a successful, earlier exit within the same fund are "recycled" into a new, perhaps less promising, investment. On paper, it looks like the fund is efficiently deploying capital, but it can make it incredibly difficult for limited partners (LPs) to track the individual performance trajectory of each underlying asset. It's like pouring different colored liquids into the same opaque container and then trying to discern the exact proportion of each. Meanwhile, complex layers of debt, preferred equity, and various tranches of common stock within a portfolio company can further muddy the waters, making it nearly impossible to calculate a straightforward return on the fund's specific equity stake.
The shift towards including these alternative investments in 401(k) plans adds a new layer of urgency to the transparency issue. For institutional investors, there’s a direct relationship, often through dedicated investor relations teams, to challenge these valuations, request more granular data, and perform their own due diligence. They have the resources and leverage to push back. An individual 401(k) participant, however, has no such access or influence. They rely entirely on the diligence of their plan sponsor and the financial advisors who select these funds. If the underlying metrics are inherently difficult to decipher, how can anyone truly assess the risk-adjusted returns or compare them meaningfully against more liquid, transparent options?
The pursuit of yield in a low-interest-rate environment has certainly propelled private equity to new heights, with trillions of dollars now under management globally. There's a persistent belief that the illiquidity premium—the extra return investors demand for tying up their capital in hard-to-sell assets—justifies the complexity. But if the methods for calculating that premium, and the very performance it's supposed to reward, are so opaque, then the implicit trust placed in these valuations by new cohorts of investors becomes a significant concern. It isn't just about whether a fund is doing well; it's about whether you can truly understand how it's doing well, and whether that success is sustainable or merely a trick of the ledger. For the broader market, and particularly for the everyday investor now entering this arena, greater clarity isn't just a nicety—it's fast becoming a necessity.
