To the casual observer, the investment returns recently announced by the California pension system might seem like cause for celebration. The state’s investments in firms that buy private companies on paper generated a 20 percent return in 2014

California's $30 billion worth of private equity investments had not come cheap, however, incurring almost $440 million worth of annual management fees paid to financial firms. But the double-digit gains helped the system generate some of the best overall pension returns in the nation -- positive news for taxpayers and for state workers who rely on the system in retirement.

Across the United States, similarly robust returns have proven key elements in the Wall Street sales pitch that has persuaded state and city pension overseers to entrust vast sums of money to private equity managers. The private equity industry has successfully portrayed itself as no less than a savior for underfunded pension systems, at once an alternative to the volatility of the stock market and a source of outsized gains. By one estimate, $260 billion of public money is now under the management of these firms.

But as Congress this week considers reducing regulatory scrutiny of private equity firms, one problem complicates the narrative: A lot of the gains the private equity industry purports to have achieved are of the on-paper-only variety. Far from cash in the bank, they are instead estimates of the value of assets that have yet to be sold -- assets that pension systems are relying on to ultimately finance benefits for millions of current and future retirees.

Those estimates are largely self-reported by the private equity firms. Soon-to-be-released research obtained by International Business Times suggests that the firms have effectively embellished their returns to make them look more attractive to pension managers.

"Private equity managers constantly insist that their investments are less volatile and more safe than the broad stock market, but that may be a matter of perception rather than reality," said investment banker Jeffrey Hooke, who co-authored the upcoming study on private equity valuations with researchers from George Washington University. "The investments in private companies may only appear safer because the private equity managers are in control of how the investments look on paper, not because the actual value of the assets are more stable or better performing."

Far from an arcane matter of financial bookkeeping, overly generous estimates of returns by the private equity industry have played a key role in placing greater shares of public money into riskier investments managed by profit-making Wall Street institutions.

“Private equity firms are going around and raising money based on this performance data, so if the values are being artificially inflated, it makes them seem like they are doing better than they are and that ends up convincing investors to put more money into their next fund,” said Jason Scharfman, an expert on due diligence at the pension advisory firm Corgentum.

One leading Senate Democrat, Elizabeth Warren of Massachusetts, seized on the new study as the latest indicator of the ways in which Wall Street's inflated valuations jeopardize Main Street's economic security.

"When retirement fund managers are unable to measure risks in careful and accurate detail, then they aren't able protect the funds or the retirees who depend on those funds,” Warren told IBTimes. “Before the crash of 2008, too many fund managers listened to sales pitches that they couldn't verify, and we saw how badly that ended."

Sen. Sherrod Brown, the senior Democrat on the Senate Banking Committee, raised concerns about Wall Street firms being allowed to self-report their own valuations.

“The retirement savings of public employees need to be properly managed by a fund and then valued by an independent party,” he told IBTimes.

By contrast, House Republicans have criticized increased government oversight of private equity firms. They have passed legislation to exempt private equity firms from SEC oversight that could more seriously scrutinize their self-reported valuations. A version of that bill is expected to be voted on in the House this week.

“No Generally Accepted Standards, Practices Or Policies”

While the private equity industry boasts of annual returns that beat the stock market, roughly two-thirds of private equity firms’ portfolios are composed of yet-to-be-liquidated companies, according to data compiled by financial research firm Preqin. That means that in many cases the annual returns touted by pension systems as smashing success stories are actually just private equity firms’ own estimates of what their portfolio companies theoretically could fetch in a sale.

Because those companies are not publicly traded and therefore not independently valued by the stock market, the estimates are akin to a homeowner being invited to make up a number representing her home value when applying for credit. Unlike a professional home appraisal, private equity firms' estimates are both opaque and difficult to verify independently -- as the California Public Employees Retirement System notes on its website: "There are no generally accepted standards, practices or policies for reporting private equity valuations."

An investment agreement between Grosvenor Capital Management and Vermont shows how the contracts signed between pension funds and the private equity firms often explicitly permit such a lack of standards. In the contract, which was obtained by IBTimes, the firm says that valuations of assets purchased with state money can be “modified” by the manager in his “sole and absolute discretion” and that such changes “shall be final and conclusive.”

In recent years, academics, government officials and pension trustees have raised concerns about Wall Street firms potentially using their valuation authority to juke the stats.

At the Securities and Exchange Commission, a top enforcement official in 2013 declared that the private equity companies that the agency had been scrutinizing were “exaggerat(ing)” the reported values of their portfolios. That declaration followed the release of studies by academic researchers finding evidence that valuations were being manipulated. The SEC subsequently reported that it found “violations of law or material weaknesses in controls” at more than half of the private equity firms that the agency investigated.

The revelations prompted Steven Judge of the Private Equity Growth Capital Council to remark: “Private equity firms work hard with auditors and company managements to provide accurate valuations of their largely illiquid holdings to their investors.”

“Grading Their Own Homework”

Yet now comes new data from Hooke and George Washington University’s Ted Barnhill and Binzi Shu that purports to prove mathematically that the private equity industry’s books are misleading.

The researchers essentially created a portfolio of publicly traded companies that they say closely resembles the kinds of privately owned companies that private equity investors buy. The researchers then weighted their public companies’ returns to reflect the same level of debt that private equity firms typically impose on their portfolio companies.

The researchers argue that their index of public companies should show roughly the same returns as the private equity industry. “All things being equal, an auto parts company that is publicly traded will have the same value as an identical auto parts company that is privately owned,” Hooke, who is an executive at Focus Investment Banking, said.

Instead, though, the private equity industry’s stated returns were noticeably less volatile than the publicly traded companies’ returns. The researchers assert that the private equity industry uses its latitude to self-value its own portfolios in order to make their returns look “smoother” than they actually are. “Investors may have been unfairly induced into placing monies into these investment vehicles,” they conclude.

John Rollins of the accounting firm McGladrey has written that “there may be an incentive to overstate asset levels to drive higher management fees.” Yet, in an interview, Rollins also said that valuing private investments can be inherently imprecise. He also said that third-party valuation can “get expensive quickly -- and those are costs paid by the investors.”

According to Jeffrey Block, who represented Massachusetts pension funds in a lawsuit against Oppenheimer that revolved around misvaluations: “When you are investing pensioners' money in nonpublic securities, the oversight and scrutiny isn’t there, and fraud can be widespread.... The solution is to hire an outside auditor who is looking for bugs in the system.”

Relatively few private equity firms employ outside consultants to authenticate their stated valuations. Private equity executive Leo Hindery of InterMedia Partners says that may be because independent valuations would challenge what he says is a problematic “don’t ask, don’t tell” dynamic.

“On one side, you can have managers who want their portfolios to look as good as possible or managers who get paid more when the valuations they calculate are higher," Hindery, whose firm's fees are not based on annual valuations, said. “While on the other side, you can have pension trustees and other investment advisers who don’t necessarily want to tell retirees and clients that the assets [in which] they’ve been investing in fact may not be doing very well. In such cases, retirees can get a valuation statement saying things are doing well when the reality is quite different.”