Two words can define the future fundraising success of a real estate private equity firm: Top Quartile. That validation of being a benchmarked high-performer is worth its weight in AUM. Fall below the fiftieth percentile and managers find themselves rethinking strategy or starting over entirely. To avoid those downsides and specifically to pave the path for growth in AUM, research has found some funds manipulate returns to boost and smooth reported results.

Fund sponsors can boost IRRs in a range of ways. Without breaking established norms they can influence returns “by strategically timing asset acquisitions, dispositions, and markdowns.” The worst actors can overtly inflate fund NAVs. Often firms may mark-to-market appreciated assets and delay marking-to-market poorly performing assets, new research on the subject noted.¹

Separate from “boosting,” firms can pursue smoothed returns by adjusting NAVs slowly to changing market conditions, thereby creating create an illusion of stability. The presumption has been that smoothed returns understate true volatility in asset values, and although that academic question is not settled, it’s true that smoothing can be influenced by management decisions and that smoothing lowers volatility and thus lowers the measures of “risk” for the fund.

The newest research on this subject examined periods when sponsors were back in the market fundraising, presumably when they were most likely to benefit from reporting higher IRRs. Unsurprisingly, reported IRRs peaked during fundraising windows, only to drift back down once commitments were secured.

Earlier investigations have assumed return manipulation was a function of fund managers who wanted to demonstrate stronger performance. But that may not be the end of the story. The new research suggests “return manipulation may instead be driven by investor demand.”

Say what? The researchers find that private equity sponsors “strategically report boosted and smoothed returns” because their investors - pension funds, primarily - want to report “higher and less volatile headline returns to their own stakeholders.” In other words, LPs want to look good too.

Is that true? If it were, you’d need evidence GPs cater to their clients and smooth and boost returns such that those returns “help” their LPs, specifically helping pension fund managers and trustees show high IRRs during their watch. The LP officials may be motivated by political pressure and in some cases re-election ambitions: Prior research “has shown that such career concerns and political constraints shape how pensions make investments… and compensate pension managers.”

This is a serious agency problem - these come up often in the Haystack. Pension beneficiaries likely care about long-term returns measured by profits or multiples. Pension managers, under short-term scrutiny, often chase headline IRRs, which can be gamed by the timing of distributions. The incentives diverge, and so does behavior.

The researchers found that returns smoothing and boosting increases when “it benefits fund LPs more and when the re-election concerns of their public pension investors’ trustees are the strongest.” But it’s not worth it for all GPs to cater to all of their LPs; catering incentives vary and the stronger the incentive, the greater the catering behavior.

“Funds at the 75th percentile of GP catering incentives report IRR boosts that are about 6× larger compared to funds at the 25th percentile,” and among the factors driving high catering incentives is how much a particular private equity fund can influence overall returns for its LP. When a single fund is large enough to matter, the incentive to please grows. The payoff is measurable—those high-catering funds deliver about 24 extra basis points of returns for their average LP compared to low-catering peers.

The study also found GPs with high catering incentives will smooth their returns more often: On average they will reduce the volatility of an LP’s portfolio “by about 10 bps per year.” Funds with high catering incentives similarly show lower volatility - betas that are about 3% lower - than funds with low catering incentives. And in down markets specifically, these high-catering-incentive GPs mask downside risk and smooth returns significantly.

Another and maybe more insidious GP incentive: looking good to new or incumbent individuals on an LP’s board when a term ends or a seat becomes open. The study found boosting and smoothing increases as “political representation” increases on an LP’s pension fund board. When trustee turnover spikes - when there’s a one-standard-deviation rise in political departures - LPs see “a five percentage point increase in annual market-adjusted NAV returns that an LP receives from its GPs.”

That finding doesn’t sit well. Nor does what follows: The timing of GPs boosted returns “correlate with higher incidences of bonuses for public pension CIOs and lower incidences of replacement for their plan’s general consultants.” Considering the evidence, the researchers found that “pension trustees’ political incentives directly shape … fund managers’ return boosting behavior.”

And if you’re wondering about the funds they studied, it felt comprehensive. The study included closed-end PERE funds pursuing the full range of strategies, each with at least 20 quarters of reported IRRs and with a vintage year of 2001 or later. They adjusted fund NAVs for cash distributions, distributions from property sales and LP contributions and flagged returns greater than public market returns during a quarter, which in part signified a “boosted” return.

In the end, we were struck by how easy return manipulation appears to be, and also surprised to learn some return boosting isn’t a form of deception — it’s collaboration. The work is a reminder that the structure of incentives matters both for the agents and the principals. Investors relying on performance data for benchmarking, fund selection, or market timing should take this agency dynamic seriously.

Who: HempWood

What: Wood that can do all the normal wood things, but it’s made from hemp, and is visually stunning.

The Sparkle: Squeezing down fiber hemp stacks with soy-based resin, the company fabricates a versatile, interior hardwood. The materials are first pressed into blocks, then cut into “lumber, flooring, panels, woodturning blanks, picture frames, and table & cabinet kits,” the company says. The product has a lot going for it: it is eco-friendly, harder than hickory, and made in the U.S. Plus it looks amazing.

More here on their origin story.

Crafting “wood” flooring:

Elephants have funerals.

There are relatively few animals outside humans that appear to mourn in a humanesque manner. Elephants have highly close-knit social groups, so when one of them passes away, the entire group experiences grief. Elephants grieve their deceased in a highly ritualistic way, sometimes laying their trunks over the body, covering the body with leaves and branches, or standing nearby as if on guard..

Link: https://brigitteganger.medium.com/elephants-grieve-a8fe4a0d62e2

Rare Footage from National Geographic

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