Oxford Professor Phalippou: Since 2006, Private Equity Has Produced Only S&P 500 Returns While Reaping $400+ Billion in Fees

The premise that private equity delivers returns better than that of public stocks has fallen apart as more and more money has chased a not-comparably-expanding universe of deals. Private equity as a share of the global equity markets has more than doubled since the early 2000s. Despite private equity funds having record levels of “dry powder,” meaning committed but unspent cash, more and more investors are throwing money at the strategy out of desperation to achieve higher returns.

We’ve also pointed out that fiduciaries like CalPERS have continued to be fanatically loyal to private equity even when its own metrics have said private equity isn’t earning enough in the way of returns over the last ten years to justify its extra risks.

Recent work by Oxford professor Ludovic Phalippou, one on the few academics not beholden to the private equity, paints an even grimmer picture of how the private equity industry has performed since 2006. As described in the Financial Times, Phalippou ascertained, using what he describes as conservative (meaning private equity industry favoring) assumptions, that the private equity industry only matched the S&P 500 benchmark. This is particularly damning, since as we have described repeatedly in past posts, the use of the S&P 500 is flattering to private equity by virtue of its average company size being much larger than typical private equity portfolio company sizes, hence you’d expect a higher growth rate. And for newbies, do not forget that the rule of thumb is that private equity should outperform the relevant public equity benchmark by 300 basis points (3%).

From the Financial Times:

US private equity managers have extracted $400bn in fees and expenses from investors since 2006 but on average they failed to beat the returns from an S&P 500 tracker fund, according to a new analysis.

The findings are an analysis by Oxford Saïd Business School based on the Burgiss database…

Ludovic Phalippou, a Saïd finance professor, said the funds launched in those 10 years have, on average, performed in line with the S&P 500, the main US equity benchmark. This delivered annualised returns, including dividends, of 8.6 per cent between January 2006 and the end of March 2018.

Nine out of 10 of these private equity funds also beat the 8 per cent annual return “hurdle” that allows their managers to claim performance fees, which amounted to an estimated $200bn.

A further $200bn was paid in management and other expenses, but there was less certainty over this data. The estimate could be conservative…

In fact, if you read Phalippou’s blog post, which gives a more detailed description of his analysis, he did indeed bend over backwards to be fair, and arguably more than fair to private equity managers. However, part of being “fair” meant using PME, which means “public market equivalent,” which is widely acknowledged to be the most accurate way to compare private equity returns to public market returns. It’s no accident that the private equity industry on a widespread basis instead uses IRR, or “internal rate of return” which is flattering. From his site:

Burgiss is perceived as one of the most comprehensive and accurate database of private equity fund cash flows….

Fact and matter is that for many years, people kept on saying that PE funds outperformed the S&P 500 by 3-4% p.a. and that was great (see a related blog). Over the last 10-12 years the S&P 500 has been doing well and now people tend to use other indices as benchmarks (e.g. MSCI world); this still has little to do with the type of companies helped by PE funds but MSCI world has the advantage of having low returns over the last decade.

To keep it simple and focused, let’s keep it to the tradition and compute PMEs with the S&P 500.

Next, let’s go on the positive side: eliminate vintage years 2016-2018 because these funds are young and as of now have a PME below 1 (i.e. underperform the S&P 500 index), eliminate debt funds, and keep only equity and real asset funds. These funds basically do either LBOs (be it applied to real estate, infra…) or venture capital no matter how they call it. We would think any of these investments has a beta above one hence the benchmark needs to be higher than the stock-market but we are on the positive side… hence ignore all that (just like liquidity issues etc.)… and select only western Europe and north America (they have the best performance)

Take ten vintage years, this brings us: vintage 2006 to 2015 and performance is as of March 2018. Total fund size $2.2 trillion, 2424 funds, average PME 0.97 (median is 0.98), TVPI (total value and distributed compared to invested) of 1.46.

You probably missed the key point in this somewhat technical discussion. Even after playing with the sample to make it more favorable to the private equity industry, both the average and median PME were below 1. Lower than one means they did less well that the stock market.

Now of course, industry stalwarts will then say, “You just need to pick the best managers!” We’ve been debunking that idea for years and we will spare you extended quotes from our archives to show that. Private equity funds do not show persistence of outperformance (as in top quartile performers don’t reliably outperform on their next fund). And on top of that, one study found that 77% of the funds can cut the numbers to make themselves look like top quartile funds!

Let’s return to Phalippou:

You can change sample construction, assumptions etc. this estimate is quite stable. For example, you could select only US LBO funds. PME for this subsample is better: 1.04 (i.e. about 1% outperformance p.a.), total size is $773 billion. Funds in the money have a total size of $567 billion and a TVPI of 1.67. Total carry would then be $76 billion.

In both cases (and in many others) the situation is the same: carry is about 10% of the amount of money raised and performance is about that of the S&P 500 index. And the absolute amount of money we are talking about is large.

For other fees (management fees, portfolio company fees, expenses) it is a lot more difficult to have an estimate. But a management fee of 1.5% of fund size for five years is a lower bound, which means 5*.015*2.2T = $165 billion. The next five years, make if one third of that amount (very much a lower bound) and you are above $200 billion. And then you would need to add all the other fees and expenses.

If the PE industry finds the above unfair despite my best effort, it is welcome to make data on fees and expenses available to a group of diversified academics and I am sure we will manage to count and end up with a precise estimate.

Now industry boosters might again say: “Ooh, a PME of above 1! See, private equity is not so bad.” Folks, a supposed outperformance of a mere 1% per year over what ought to be a flattering index is insufficient. Remember, the bogey is 3% outperformance of stocks.

Consider one risk of private equity: the need to stay liquid enough to meet capital calls, which come, depending on the fund, on a five or ten business day notice. Missing a capital call has draconian consequences, typically having your entire past investment divvied up among the rest of the fund investors. And this risk is real. During the financial crisis, CalPERS had to dump stocks at the bottom of the market to raise money to meet private equity capital calls.

There is a cost to keeping funds in lower-returning investments, often a chunk in cash equivalents, to have the funds on hand to meet those capital calls. Phalippou and I have estimated it separately at 100 basis points over a fund’s life.1

Here is the fun part: So far, the industry does not dispute Phalippou’s finding, that private equity firms earned 8.6% over the last decade plus, which is on par with S&P 500 returns. Again from the Financial Times:

The American Investment Council, a lobby group for the private equity industry, disputed the data…

The AIC’s analysis found the median annualised return over the past 10 years from private equity was 8.6 per cent (net of fees), based on data from 163 US public pensions schemes. This was higher than the median 6.1 per cent return earned from public equity by the same pension schemes.

Did you catch the sleight of hand? We don’t know how AIC chose those 163 funds. Pension & Investments surveys the largest 1000 retirement plans every year, so AIC has a lot of room for artful sample selection.

But AIC came up with exactly the same private equity returns that Phalippou did. They misleadingly to throw cold water on his findings by showing that their chosen group fell way short of the S&P 500 in their public stock investing. In other words, all of these pension funds should fire their entire public equities investment teams and dump the money in Vanguard’s S&P 500 fund.

Indeed, we’ve pointed out from time to time that CalPERS, despite running a big S&P index fund in house, is one of those big laggards. In CalPERS’s case, the causes for big-time underperformance have included:

Making an anti-dollar bet by putting half the public equity portfolio into foreign stocks at the start of a strong-dollar market. This alone appears to have had a large negative impact on returns

Getting out of tobacco stocks at the worst possible time

It’s distressing to see CalPERS and other investors who ought to know better act like private equity cult members. If Financial Times columnist John Dizard is right, that the sharp drop in copper prices is a warning that markets are “not far from a more general sell-off in risk assets,” it would really be a good idea for them to wean themselves of that Kool-Aid.


1 Banks developed a product called “subscription line financing” that would have allowed the fund itself to meet capital calls in the early years, begging the question of what investing in private equity actually meant. The objective was to goose the IRRs, since in the first year or so of a fund, cash goes out, the purchased companies are valued only at par, and the investors also have to pay fund fees and expenses, so the returns are negative. If you borrow to invest, then the returns are infinite!

This idea was briefly fashionable and then started going out of vogue when influential fund managers, in particular Oak Tree’s Howard Marks, spoke out against it (see here and here).

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  1. Steve H.

    “In other words, all of these pension funds should fire their entire public equities investment teams and dump the money in Vanguard’s S&P 500 fund.”

  2. johnnygl

    It seems interesting that as the field of private equity has grown, the broad shape of the fund mgrs looks an awful lot like active mgrs of mutual funds.

    1) a supermajorty of underperformers than don’t beat the index.
    2) the narrow subset that does beat the index varies a lot from year to year, with no one beating the index for a sustained period of time.

    These are the characteristics in the mutual fund mgt landscape that led to the rise of indexing as investors realized their money managers were basically overpaid and worthless.

    Are we likely to see a slow motion repeat of this same process?

  3. David W

    I’m by no means an expert on these things, but I have enough experience to speak knowledgeably about them – including PME. You miss a couple of important points (though I didn’t click through to the source material).

    1. Private and public equity are not the same asset classes so there’s a portfolio benefit by having exposure to both. Adding PE to the portfolio moves the frontier outward rather than merely shifting along the existing curve.

    2. While the PME has some probative value in comparing these two asset classes, it accepts a priori that the period of time being measured is a standard sample and it conflates the two regardless of their inherent differences.

    Picking a single 10-year period isn’t sufficient to recommend a permanent shift to 100% public equities. The PME for every fund EVER needs to be considered. Without getting into a pissing contest on methodologies, institutional bias, and any number of other rabbit holes, I’d put CA’s data down as a contraindication of Prof. Phalippou’s conclusions.


    1. Badbisco

      Private equity had approx. a 0.69 correlation with the Russell 3000 over the last 20 years. Beyond having a higher expected return than public equity, this correlation leads to lower volatility, reducing how much volatility erodes the portfolio’s return over time.

    2. Yves Smith Post author

      Help me. Even if we accept the premise that private equity is an “asset class” as opposed to a sub-strategy in equities, PME is accepted across academia as being the best measure of private equity returns and vastly superior to IRR in comparing private equity results to that of other investment strategies. You are barking up the wrong tree in trying to challenge the use of PME. See the Kauffman Foundation, for instance, in its classic report, We Have Met the Enemy and He Is Us (emphasis original):

      The advantage of PME analysis is that it establishes a consistent standard of performance measurement among VC funds, as well as between public and private equity managers.

      Vintage-year and top-quartile measures can be misleading due to their reliance on IRRs that are vulnerable to ‘manipulation’ in the short term and are not persistent over the term of a fund’s life.

      The claim that private equity and public equity are separate asset classes is specious even though it is widely touted. Private equity is levered public equity + lying about valuations in bad markets and at other times.

      The reason PE does not track levered equity more tightly (which you could do on your own, in Germany, where investors are skeptical of PE, institutions achieve what they view as a similar level of risk by levering their entire portfolio) is due to private equity firms giving themselves falsely high valuations during bear stock markets, around the time of raising a new fund, and for holdings late in the fund life (dogs held at par that are often eventually dumped at losses). I’ve discussed this at length in past posts, and the “lying in bad markets” aka “smoothing” is even more perversely seen as an advantage by investors, since they like publishing falsely high portfolio values in bad markets. See here for one of many examples:

      The private equity industry does have an argument for this troubling “trust me” setup: that the cost of valuing portfolio companies by an independent party like Houlihan Lokey would be on the order of $30,000 per company. Multiply that by, say, 20 companies four times a year, and you’ve got $2.4 million in costs. On a $1 billion fund, that’s close to a 0.25% annual cost on the commitment amount, which would represent a meaningful drag on returns.

      But here’s the flip side: If you allegedly can’t afford to have adequate investor protection, should you be investing in that strategy at all, particularly in light of the considerable latitude that general partners have in computing these estimates?

      The dirty secret of these valuations is that jiggering key assumptions, like the discount rate, margins, revenue growth, reinvestment requirements, within ranges that are plausible, results in a very large range of possible values. It’s not uncommon to find that changing the assumptions would result in a valuation of ten times what you’d get using conservative assumptions.

      The truth is the portfolio company valuations are nothing more than a general partner’s opinion.

      And there is strong evidence that valuations are often phony, as in artificially high…

      So why don’t investors look at the valuations more skeptically? They view those phony smoothed valuations as a feature, not a bug. Private equity researcher Peter Morris called it “A triumph of accounting form over economic substance.”

      One big reason is that when most financial markets are tanking, private equity looks less bad by virtue of under-reporing its price declines.


      And later in that same post:

      Chris Ailman, the chief investment officer of CalSTRS, said his institution looked to private equity for returns, and their models depicted it as highly correlated with public equity. That is tantamount to saying that they don’t treat private equity as having lower risk than stocks, so they don’t (or at least don’t profess) to seeing the fudging of the valuations in bad markets as a plus.

      But even though Ailman, like the more savvy investors who correctly see that private equity is highly correlated with stocks, and hence offers virtually nil in the way of diversification benefits, CalPERS wants to have it both ways. As we showed in our post earlier this week, CalPERS snuck in “observed volatility” to measure risk, which is based on the accounting values that [Bob] Maynard [of Idaho PERS] correctly depicts as phony.

  4. Badbisco

    Great post, there’s a lot of concern in the industry that it’s now difficult to find potential PE deals at good prices. Institutional investors fear the new low-growth environment and have pushed into PE as a way to try and bring up the expected return of their portfolios. The result is more and more general partners bidding on potential acquisitions.

    Minor quibbles:

    – Portraying a decent-sized non-US allocation as an anti-dollar bet – The non-US allocation is certainly impacted by the dollar rising/falling but the domestic/international equity split is often determined by the global equity benchmark in order to have market neutral exposures. The broad MSCI AC World Index was 52.5% US exposure and 47.5% Non-US exposure as of 6/30/18, so an institutional investor with a 50% global equity IPS target, like Calpers, would be approx. 26% domestic and 24% non-US. A significant non-US allocation often reflects a passive allocation decision to match the global opportunity set rather than an active bet on currency movements. A lower non-US allocation would actually be the active currency bet, but on a stronger dollar.

    – Forced Selling to meet Capital Calls (CC) – Typically, institutional investors with a mature PE program keep around 1% in cash/money markets. They are also continually processing a stream of distributions in from their stable of PE funds. The distributions help fund the CCs while the cash buffer covers any outliers or timing issues. There is very poor planning or potentially a lack of sufficient vintage year diversification if there are ever significant sales needed to fund CCs.

    – Cash Drag to Fund CCs – Can you point me to where you calculate the 1% drag? If calculated on the overall portfolio, it seems like it should be lower. The median endowment returned 7.9% annually over the 5 years ending 6/30/17 (N-C Study of Endowments 2017), so a 1% cash allocation to fund CCs, even with a zero return deposit account, would only be a 8 bps cash drag on the total portfolio.

    Please don’t take the minor quibbles as troll-work, I’m a long-time reader who loves NC and agrees that PE isn’t actually as attractive as many feel.

    1. Yves Smith Post author

      Re your first point, CalPERS runs custom indices, and so they pick the index to judge the success of what they’ve decided to do strategically, not the reverse, as your statement implies. And that is normal practice in investment management.

      CalPERS greatly increased its foreign stock allocation IIRC around 2010. And the issue is US portfolios underperforming the S&P 500 and why that would be the case and in CalPERS, the decision to move into foreign stocks in an big way was the single biggest driver of underperformance.

      I don’t see a reason for investors with dollar only liabilities to have strong foreign currency exposure save for diversification, and now that we have many investors who trade like the old global macro types, stock markets around the world are far more correlated than in the past, so the diversification benefit is much lower (witness the risk on/risk off trades of 2013 and 2014). When I was a young un on Wall Street, the rule of thumb for institutional investors was that 20% foreign stock holding was the level needed to achieve sufficient diversification. Note that CalPERS also has foreign equity exposure, albeit at a lower level, though its private equity portfolio.

      Re your second point, this is precisely what happened to CalPERS in the crisis. Distributions dried up and CalPERS kept being hit with capital calls. It had additional liquidity issues due to having had a big securities lending program and suffering counterparty defaults.

      Re your last point, Phalippou and I both came to the same result, and I got the cash flows but only approximate commitment dates (bizarrely, CalPERS fought my getting exact commitment dates) for CalPERS entire PE portfolio from inception through 2014. Phalippou has similar granular data from his academic work. He’s thrown this observation out as an aside in one of his papers.

      Your comparison is apples to oranges, The issue is the impact of accommodating capital calls on PE returns, not on total portfolio returns, when among other things, the size of the total portfolio is a big multiple (for CalPERS, over 12x) the size of the private equity program. That cost comes at the very beginning of the investment. As you ought to know, when computing a DCF, anything that happens in the early years has a vastly greater impact on total returns than if the exact same cash flows (in this case, cost) occurred later. And in this case, that “cost” takes place from the get go.

      1. BadBisco

        Thanks, appreciate the thoughtful responses.

        One – In that case, the CalPERS committee is making very tricky tactical bets when developing their asset allocation rather than setting strategic long term guidelines. Relative Dollar strength against foreign currencies is typically cyclical over the long term, so making tactical short term changes is foolish. If the committee or their staff could forecast currency movements effectively then they wouldn’t be at CalPERS, they’d be running a global bond fund.

        Two – Sounds like more bad decisions/planning. Seems to be a trend for them. Wonder how much is driven by a well paid staff desperate to prove they add value.

        Three – Good argument, I’m used to thinking of cash drag effects on the whole portfolio rather than linked to a single segment or investment. I’ll eat the apple and the orange.

  5. Tomonthebeach

    I wonder why this is news. Paul Solman at PBS and the late Loius Rukheyser have been saying this for many decades. The results of analyses always replicate. I guess we repeat these studies now and then just in case somebody has discovered some AI tool that gives them a huge edge.

  6. Chauncey Gardiner

    $400 billion in conservatively estimated management fees, eh?… Nice cash cows… for the general partners/managers.

    How private equity valuations are established for benchmark comparison purposes is unclear and seems to me to offer opportunity for gaming the numbers. Valuations can only be objectively established when an investment is sold. Hence, the old market adage, “Prices are set on the margins.” Since many private equity investments are highly debt-leveraged buyouts or are in sectors that are “out of favor”, I question their comparability from a risk-return perspective to the companies that make up the S&P500 index. How is the discount rate used to value net cash flows for the internal rate of return (IRR) established?

    Further, assuming they can be and are being objectively and accurately valued, that private equity investments are not “beating” the S&P500 index by an appreciable net amount after fees and expenses that compensates investors for their higher risk causes one to question their general partners’/managers’ representations of these investments as an “alternative investment offering higher returns”.

  7. ewmayer

    When one factors in PE’s role in the overall economy, things are in fact much, much worse than the mere returns-numbers indicate. How many once-viable businesses did the PE asset strippers destroy via their now-standard lot-n-scoot MO, and how much did that exceedingly non-creative destruction via outright pillaging-to-death contribute to PE returns?

  8. p. fitzsimon

    And we’re supposed to sympathize with unions that invest in private equity, the same entities that often destroy jobs of other workers.

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