Massaging returns during times of volatility is a common practice in private equity, but investors should be aware of the pros and cons.

“Smoothing” returns is Zen for VC funds and possibly for investors too. Photo by form PxHere

In early December the two largest, non-listed real estate investment trusts ran into trouble as investors wanted to pull out their money in response to rising interest rates and a looming recession. They have had to limit withdrawals from the funds, as investors increasingly want to turn to less risky bets with higher returns.

The question of returns is at the heart of the issue. In the case of the $69bn Blackstone Real Estate Income Trust, as of early December the fund´s webpage claimed the fund itself was up 8.5% year-to-date on a no-sales-load basis (Note: there seems to be a problem accessing that page since but there is an update on portfolio performance from November 2022 still available in pdf format on their web, slightly restating the figure as “8.4% net return for investors” with a rather long footnote to it).

With the S&P REIT Index, tracking listed real-estate investment trusts (REITs), down 20% YTD, it doesn’t seem likely that Blackstone’s unlisted REIT would have really outperformed so well, especially when their investors were rushing to withdraw en masse.

This raises a question, also, about private equity and venture capital firms — to what extent are they smoothing financial returns and how should investors who take limited partner (LP) stakes in these firms respond to that?

“Phony happiness” and “volatility laundering”

Using accounting rules to “smooth” the returns in private equity is nothing new. Clifford Asness, managing director and founding principal of AQR Capital Management Capital, dubbed this practice “volatility laundering” in a tweet earlier this year.

Back in 2017, the CIO of the Public Employee Retirement System of Idaho reportedly referred to this as the “phony happiness” of private equity. Even earlier, in a 2014 paper, scholars Welch and Stubben showed that “cost-based methods of accounting understate the systematic risk of private equity, creating an illusion of diversification.”

They also demonstrated that, if private equity firms should adopt fair value accounting standards as opposed to cost basis, then their reported volatility would significantly increase and likely make it higher than that of the public markets.

Willingly duped?

There is plenty of evidence to suggest, however, that investors don’t mind these manipulations. A recently published paper by University of Florida scholars Jackson. Ling and Naranjo, entitled “Catering and Return Manipulation in Private Equity” examined a large dataset of returns of private equity real estate (PERE) firms active between 2001 and 2019. The analysis found that “PERE GPs do not appear to manipulate interim returns to fool their LPs, but rather because their LPs want them to do so.”

The paper also states that “manipulations are widespread, economically significant (amounting to about 470 bps), and accomplished primarily through a diverse set of timing strategies” when it comes to the purchase or sale of assets by these firms.

However, it highlights that the “prevalence of timing strategies, rather than explicit NAV manipulations, suggests that only some forms of manipulation are acceptable to LPs.” And further, the “average GP that manipulates IRRs successfully raises capital for a follow-on fund and manages larger commitments from their LPs.”

Why are LPs so willing to be lied to? The short answer is probably because it makes things look a little better, at least on paper, while they weather an economic storm.  

VC firms are arguably different from their leveraged private equity counterparts, but assets on their balance sheets would have been likely to suffer from just as much volatility, if they had been marked to market in a timely fashion.

Moreover, corporate venture investors that are taking LP stakes are, at least in theory, even more incentivised to have VC firms report “smoother numbers” during a downturn. This would be particularly true for those facing short term pressures on a quarterly basis like most listed companies do.

What should corporates keep in mind? These practices are fairly commonplace in private equity, they are not illegal nor do they go against accounting standards.

If “massaging” returns by VC finds helps keep things on a more even footing through what may be a volatile economic period, corporates can use the practice to their advantage, much like the real estate private equity investors.

But it is worth being aware that it could also bite them at some stage, if funds are forced to limit withdrawals or take measures to prevent LPs from cashing out.

Email the author Kal Andonov with story tips and ideas at

Kaloyan Andonov

Kaloyan Andonov is head of analytics at Global Corporate Venturing.