Catering and Return Manipulation in Private Equity

We provide evidence that private equity (PE) fund managers manipulate returns to cater to their investors. Using a large dataset of PE real estate funds, we show PE fund managers overstate returns if they oversee a larger share of their investors’ assets, and doing so has a more significant impact on investors’ reported returns. Additional results are inconsistent with models in which investors punish or are deceived by manipulations. In contrast, our results highlight an underlying tension in PE performance: the “phony happiness” some PE investors receive from overstated and smoothed interim returns due to agency frictions within their organizations. For helpful comments and discussions, we thank Michael Ewens, Minmo Gahng, Andra Ghent, Jacques Gordon, Bill Hughes, Chris James, Steve Kaplan, Greg MacKinnon, Joseph Pagliari, Martha Peyton, Ludovic Phalippou, Tim Riddiough, Jay Ritter, Yuehua Tang, several private equity professionals, and seminar participants at the University of Florida. First version: April 2022. †University of Florida, Finance Ph.D. Student, E-mail: blake.jackson@warrington.ufl. edu ‡University of Florida, McGurn Professor of Real Estate, E-mail: david.ling@warrington.ufl. edu §University of Florida, Susan Cameron Professor of Finance and Chairman of the Eugene F. Brigham Finance, Insurance, and Real Estate Department, E-mail: andy.naranjo@warrington.ufl. edu Private Equity (PE) plays an increasingly central role in the portfolios of institutional investors and the overall economy, raising more than $5 trillion globally over the period 20172021 (Bain 2022). Recently, regulators suggest that some investors make these commitments based on reported returns that are boosted or otherwise manipulated by some PE managers. Several recent studies investigate this “window dressing” in PE, similarly suggesting that return manipulations are an attempt to fool potential investors. Yet, PE investors are sophisticated, raising an alternative possibility that PE fund managers may manipulate returns because some PE investors prefer boosted interim returns. In this paper, we provide empirical support for this alternative view of PE fund manager window dressing based on the idea that some PE fund managers manipulate interim returns in a manner consistent with their investors’ desires. Similar to the idea that banks design financial products to cater to yield-seeking investors (e.g., Célérier and Vallée (2017)) or firms issue dividends to cater to investor demand for dividend payments (e.g., Baker and Wurgler (2004)), we argue that PE fund managers boost interim performance reports to cater to some investors’ demand for manipulated returns. We o er a simple explanation for this catering phenomenon in PE: some PE investors face agency frictions within their organizations that make manipulated interim returns attractive. Our catering view of return manipulation is related to the emerging view that PE commitments are driven in part by the slowly updated, or “smoothed,” nature of PE returns. Cochrane (2022, P. 8) asserts: Why do so many institutions, like our endowments, prize assets like private equity, venture capital, and real estate with no clear market values? Well, perhaps they like those assets precisely because the assets are hard to mark to market, easy to just pay out 5% of a made-up value, not to sell in a panic, and not fire the asset manager based on an irrelevant price—or rather a price that is only relevant when combined with the state variable, which accountants and oversight committees are no better at evaluating than our hypothetical spouse. Bob Maynard, the Chief Investment O cer of Idaho’s Public Employee Retirement System, 1See recent coverage of the U.S. Security and Exchange Commission’s investigation of PE reporting practices and fees (https://on.wsj.com/3KeIEuF and https://on.wsj.com/3Jnr3PU). 2For example, Barber and Yasuda (2017) show that buyout and venture fund performance peaks during fundraising, especially among managers with poor track records, and Brown, Gredil, and Kaplan (2019) show that managers that overstate asset values often fail to raise follow-on funds.