The Use of Return Smoothing in
Private Equity

 

By Gavin Korn

 

Private equity has long occupied an opaque segment of global capital markets. Characterized by its illiquidity, complex valuation methodologies, and restricted investor base, the asset class has traditionally operated outside the bright scrutiny that surrounds public markets. Yet in recent years, scholars and practitioners have drawn increasing attention to a significant practice within private equity: the systematic manipulation of interim returns—not with the intention of deception per se, but as a form of strategic appeasement to investor preferences. Referred to as return smoothing or more pejoratively as volatility laundering, this practice serves as a mirror not merely of market dynamics, but of the institutional incentives and psychological biases that govern modern capital allocation.

 

In a compelling working paper, Jackson, Ling, and Naranjo (2024) articulate the argument that general partners (GPs)—the investment managers of private equity funds—engage in interim return manipulation not primarily to mislead their limited partners (LPs), but to cater to their underlying need for stability in returns. The authors term this behavior “catering,” to suggest a mutual understanding between both sides of the investment relationship. Rather than seeking sharp insights into economic reality, institutional LPs often prefer performance profiles that are consistent, measured, and devoid of the volatility inherent in public equities. As the authors note, “[Managers] do not appear to manipulate interim returns to fool their investors, but instead to cater to their investors’ demand for smoothed returns” (Jackson et al., 2024, p. 4). The smoothing of returns, in this view, becomes not a pathology of finance, but a rational—albeit opaque—response to the political economy of investment management.

 

Clifford Asness, a prominent hedge fund manager and commentator, expands this critique by introducing the concept of volatility laundering. He argues that the apparent smoothness of private equity returns is the result of infrequent pricing rather than genuine economic insulation from market shocks. Illiquid assets are not marked to market daily; instead, they are appraised quarterly or at even longer intervals. This temporal discontinuity enables fund managers and their investors to suppress the visible manifestations of volatility. Asness wryly observes that “if public equity managers could choose when to mark their portfolios, they too would appear heroic.” (Asness, 2023).

 

For investment funds that hold illiquid assets, the latitude given to GPs often actually extends beyond mere timing of their portfolios’ valuation. Many investment funds’ governing documents allow the GPs themselves, or outside firms hired by the GPs, the right to unilaterally determine the “net asset value” (NAV) of their portfolios. NAV in private equity is the value of the fund's assets minus its liabilities, often assessed on a quarterly basis. The determination of an investment partnership’s NAV over time is used to determine not just investment performance, but also the value at which investors can redeem their investment, and the extent to which the GPs are compensated. (Brown and Nykyforovych, 2025).

 

Without true third-party valuations and objective standards for those valuations, NAV determinations are obviously open to subjectivity and manipulation.These practices are not without consequence. At a micro level, return smoothing distorts the risk-return profile of private equity, potentially misleading investors who rely on reported metrics for performance evaluation. More critically, at a systemic level, such obfuscation may hide the buildup of latent risks. If institutional investors—such as university endowments, sovereign wealth funds, and public pension systems—anchor their portfolio models to artificially stabilized valuations, they may misallocate capital, underestimate drawdown risk, and adopt leverage profiles that are unsustainable under stress conditions.

 

The incentives underpinning these practices are formidable. Compensation structures for asset managers are frequently aligned with short-term optics rather than long-term performance. Executives overseeing endowments or pension funds are often rewarded for the appearance of consistent, positive returns—particularly those that diverge favorably from public benchmarks.

 

Defenders of return smoothing suggest that it serves a valuable behavioral function. By muting market noise, private equity may protect long-horizon investors from the behavioral pitfalls of panic and short-termism. If smoothed returns help institutional investors maintain discipline and stay invested through volatility, then some argue this manipulation may be efficiency-enhancing in the aggregate. Moreover, given the illiquid nature of the underlying assets, interim volatility may have limited bearing on ultimate outcomes. From this perspective, the suppression of interim volatility is less a lie than a strategic silence.

 

Ultimately, the phenomenon of return smoothing in private equity is emblematic of a broader tension in finance: between truth and utility, between signal and perception. Financial reporting is not merely a neutral act of information transmission—it is shaped by incentives, expectations, and institutional demands. In a world increasingly governed by allocative algorithms and data-driven oversight, the manipulation of volatility—even if tacitly sanctioned—should prompt critical scrutiny.

 

If private equity is to justify its expanding role in institutional portfolios and public discourse, it must confront the costs of its manufactured calm. The pursuit of capital stability should not come at the expense of informational integrity.

 

References

 

Asness, C. (2023). Private equity and the illusion of low volatility. AQR Capital Management. https://www.aqr.com/Insights/Research/Alternative-Thinking/Private-Equity-and-the-Illusion-of-Low-Volatility

 

Brown, G.W., Nykyforovych Borysoff, M. (2025). Net Asset Value in Private Equity. In: Cumming, D.J., Hammer, B. (eds) The Palgrave Encyclopedia of Private Equity. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-031-81653-6_9

 

Jackson, B., Ling, D. C., & Naranjo, A. (2024). Catering and return manipulation in private equity [Working paper]. SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4244467