How Allocators Are Complicit in the Manipulation of PE Returns

Some private equity investors get “phony happiness” from overstated and smoothed interim returns, according to new research.

Illustration by II

Illustration by II

There’s plenty of evidence that private equity managers manipulate fund returns. But new research points to some surprising reasons why it happens and asserts that investors are complicit — at least indirectly.

A new paper from three scholars at the University of Florida provides evidence that asset managers manipulate interim fund returns because that’s what investors actually want. Previous studies have shown that managers doctor returns to boost fundraising.

The Florida academics set out to test whether allocators’ attraction to the low volatility of private market assets is somehow behind their complicity with managers’ manipulation of returns. (Private market assets exhibit less volatility than stock and bonds simply because they are priced quarterly rather than in real-time or daily.)

“Our results highlight an underlying tension in PE performance: the ‘phony happiness’ that some PE investors receive from overstated and smoothed interim returns due to agency frictions within their organizations,” wrote the authors. For example, they found that underfunded pensions are more likely to invest a higher portion of their portfolios to private real estate funds than to funds that invest in equivalent publicly traded securities. One of the authors, Blake Jackson, told Institutional Investor in an email that investing in private markets funds “can artificially reduce the reported volatility of [public pension] funds.”

Using data from 2001 to 2019 on private equity real estate funds, the research shows that managers exaggerate returns when they oversee a larger share of their clients’ overall assets. The authors also find evidence that investors aren’t deceived in the process and don’t punish managers for manipulating returns. Commercial real estate funds are the second largest private markets asset class.

As stated in the paper, “If a [manager] boosts or smooths returns, perhaps by strategically timing asset acquisitions and dispositions or by misstating the values of underlying assets, investment managers within LP organizations can report artificially higher Sharpe ratios, alphas, and top-line their trustees or other overseers. In doing so, these investment managers, whose median tenure of four years often expires years before the ultimate returns of a PE fund are realized, might improve their internal job security or potential labor market outcomes.”


Ninety-three percent of these managers that exaggerate returns raised subsequent funds, according to the paper. In addition, the more an investor puts into a PE fund, the more likely the manager inflates the internal rate of return, a popular measure of performance in private equity.

“If investors punish IRR manipulations, we would instead expect a negative link between [investors’ PE] allocations and manipulation propensity,” the authors wrote. “These results are therefore consistent with the view that some PE fund managers manipulate interim returns in a manner consistent with their investors’ desires.”

On average, PE managers manipulate their IRR figures by 6.4 percentage points for allocators contributing above the median share of assets in the fund, according to the paper. For those contributing below the median share of AUM, PE managers only inflate the performance by 1.1 percentage point. The more assets an investor puts into a PE fund, the more sensitive it is to the fund’s performance. The fact that PE funds inflate numbers more for more sensitive investors proves that return manipulation caters to some investors’ demand for return manipulation, according to the paper.