As more and more money has been chasing deals and private equity transactions have been consummated at nosebleed prices, the evidence that it’s not an attractive investment strategy has only continued to mount. As we’ll discuss, that raises the question of why investors continue to throw money at an assured loser on a risk/return basis.
The latest negative finding comes from Ludovic Phalippou, an Oxford professor, reported in the Financial Times. We wrote up an earlier iteration of Phalippou’s analysis, that just using very simple but solid metrics, private equity did not outperform public equities.
That conclusion is deadly. Private equity is illiquid. Investors sign up and what happens to their money, as in when they get capital calls and when they get their funds back, is entirely under the control of the general partners. By contrast, with stocks, you are in control and can buy and sell readily, save if you have been so foolish as to accumulate a ginormous position relative to the float or want to get out when markets are plunging.
As a result, academics have for decades, as a matter of course, treated private equity as having to beat public market returns, with 300 basis points over the S&P 500 as the most common threshold.1
Phalippou’s new paper adds an even more troubling conclusion: that since 2006, the economic benefit of outperformance of private equity was retained by the fund managers and not shared with investors. In other words, private equity did outperform public stocks on a gross basis, but what investors got net of the on-average 7% annual fees and costs left them in pretty much the same boat as public equity investors, save for the much more risk part.
And the Financial Times also pointed out that Phalippou isn’t the only expert to find that private equity is no longer delivering returns that justify investing in it. Notice also that Phalippou’s analysis is historical; he does not put much weight on the notion that private equity, being levered equity, will be more exposed to downside risks as Covid-19 ravages the economy.
First, from the abstract to the paper, which we have embedded at the end of this post (emphasis original):
Private Equity (PE) funds have returned about the same as public equity indices since at least 2006. Large public pension funds have received a net Multiple of Money (MoM) that sits within a narrow 1.51 to 1.54 range. The big four PE firms have also delivered estimated net MoMs within a narrow 1.54 to 1.67 range. Three large datasets show average net MoMs across all PE funds at 1.55, 1.57 and 1.63. These net MoMs imply an 11% p.a. return, which matches relevant public equity indices; a result confirmed by PME [public market equivalent] calculations. Yet, the estimated total performance fee (Carry) collected by these PE funds is estimated to be $230 billion, most of which goes to a relatively small number of individuals. The number of PE multibillionaires rose from 3 in 2005 to 22 in 2020. Rebuttals from the big four and the main industry lobby body are provided and discussed.
If nothing else, be sure to read the Introduction. Phalippou explains how the math of private equity could never add up by going though all of the costs of making investments: the acquisition costs, interest charges, the ongoing (larded up) costs of supervision, the higher-than-for-comparable-companies executive pay, and last but far from least, private equity management fees. Here is the high level computation:
Consider the aggregate value of all companies subject to an LBO in a given year: they have earnings of $60bn, an Enterprise value of (10x earnings) $600bn, split between two thirds of Debt ($400bn) and one third of Equity ($200bn)…
Hence, the deployment of this money comes with at least a $100bn bill. If investments were liquidated the next day, the equity would be worth $200bn. Hence, what needs to be recouped for the equity holder is an amount equal to half the investment made; over just four years!…
Given the costs, leverage employed, and that the value of (public) equity historically increased by 11% p.a., the value of private equity needs to increase from $200bn to twice as much ($400bn) to break-even (Table 1). Absent an increase in valuation, organic growth in earnings would then need to be 11% p.a., which seems unrealistically high. Over the past two decades, valuations did increase and a lower earnings growth could then accommodate a doubling of equity value. Going forward, it may be more difficult. If these huge, and mostly fixed, costs were just about covered in a high-return market, then a low-return market might pan out differently….
I also show that large pension funds have earned about $1.5 (net of fees) per $1 invested in PE funds (both since 2006, and since inception). At least since 2006, this return the same as what public equity has returned. The big-four PE firms, to which many multibillionaires are affiliated, seem to have delivered about the same. The average PE fund, too, delivered about the same. A large fund for which I have (nearly) full details on fees and expenses, also generated 1.5x capital invested and the cost to investors was $1.4bn of carry and $1.4bn of other fees (management fees, expenses, portfolio company fees); fund size was $10bn.
This wealth transfer might be one of the largest in the history of modern finance: from a few hundred million pension scheme members (plus Endowments, Sovereign Wealth Funds, Family offices, etc.) to a few thousand people working in private equity. How could this be an economic equilibrium?
The number of private equity barons with personal fortunes of more than $2bn has risen from three in 2005 to 22, according to a new analysis which estimates investors paid $230bn in performance fees over a 10-year period for returns that could have been matched by an inexpensive tracker fund costing just a few basis points….
Other recent analysis has drawn similar conclusions.
A report published in February by Bain & Company found investors did better from tracking the S&P 500 over the past decade than investing in US buyout funds.
A recent analysis of 717 private equity groups by Victoria Ivashina and Josh Lerner, two Harvard Business School professors, said the division of profits among senior partners depended on whether they were founders of the partnership and not on their record as investors.
Phalippou also addresses why investors have been unwilling to face up to these sorry facts, and cling doggedly to the “private equity outperforms” myth. First is that the 100,000 people investing in private equity are not about to damage their careers by questioning the purpose of their job. The higher ups, including the trustees, don’t want to admit they’ve been wrong.
Outsiders find it hard to make effective challenges. The industry is sufficiently complex that it’s easy to get important details wrong (even if they don’t change the conclusion) and open oneself to criticism of not being knowledgable enough to be worth listening to. Phalippou said it had effectively taken him 15 years to write this paper. And even when you do get it right, you are up against a much larger number of people keen to defend their meal tickets.
I would add these reasons for investors accepting such a bad deal (we haven’t even mentioned the refusal to account for fees and costs, the tricky contracts, the grifting, and the over-the-top secrecy demands):
Soft corruption. The institutional investor staffers tasked to overseeing their fund’s private equity investments go to annual meeting, always at glamorous locations with fine food, wine, and top of the line entertainment (such as Elton John) paid out of their fund’s pockets, not by the fund managers. Similarly, at universities, private equity kingpins and firm partners are a top target for donations. Can’t ruffle their feathers by having the endowment ignore private equity.
Overt corruption. Remember that CalPERS’ former CEO is in Federal prison for taking cash in paper bags from Apollo and four other Apollo-connected fund managers? Private equity partners are often major political donors. It’s also widely believed that they will press the executives of portfolio companies to contribute to their preferred candidates. Needless to say, public pension fund board members and executives at a minimum might be reluctant to cross these heavyweights.
As a prominent CalPERS beneficiary pointed out by e-mail:
The mania for looting billions via unconscionable do-nothing fees paid to Private Equity arose during the Schwarzenegger administration — after the California GOP spent more than a decade trying to figure out how to loot the trust fund. Rather than tamp-down the pillage, the Dems have simply been tapping-into the graft by re-branding themselves as “GOP-lite” in order to make themselves palatable to the donor class, along with setting-up some of their lobbyists as mini-Schwartzmans.
The ludicrous tribute being paid to these clowns is a feature, not a bug. Look into The enormous amount that PE donates to politicians on OpenSecrets.org. Follow the money.
Even though it appears that there is no obvious way to stop the destructive private equity juggernaut, one has to remember economist Herbert Stein’s observation: “If something cannot go on forever, it will stop.” Hedge funds had a similar long run as investor darlings until the unattractive returns became too evident and widespread to tolerate. So unless the industry acts wildly out of character and reduces how much it takes from investors’ pockets, something will have to give.
1 Note that this 300 basis point risk premium is a convention; I have yet to see an analysis that explains why that particular level is warranted. North Carorlina’s former chief investment officer Andrew Silton has argued the risk premium should be 500 to 800 basis points.SSRN-id3623820
I have a theory, which goes not just across the PE, but hedge funds and banks. That is, beyond a certain size, looting is the only way. Because:
– the amount of cash they have to deploy is too large to deal with efficiently, but more money = easier to hide looting;
– the competition is removed, making looting clients even easier;
– the leadership gets more and more socio/psychopatic as the company grows (power-wise), where they care about the score (i.e. money) more than the game (i.e. making sensible investments);
– specific to PE, and related to point 1 and 3, it’s much easier for PE to deploy they money in financial engineering than genuinely turn around the company (which was usually a PE sponsored management buy-out, but when I was asking about those in the last few years it wa “why would we do that when we can get more money faster with less fuss?”).
One could argue that the PE never cared about the game and only ever about the score, but I know a number of small/midsized PE where it wasn’t the case (they operated mostly in the management buyout space). But in the last few years, it was harder and harder for them to compete agains BlackRocks and like of this world, and in the small/medium size against family offices (from what I’ve seen, larger FOs now turned often to a PE/VC shops, but it’s anecdotal).
Is helicopter money a factor with private equity?
Please wash your mouth out. QE is not helicopter money. It is an asset swap.
However, super low (as in negative real) interest rates did help private equity. It made safe investments unattractive to long-term investors (the returns were lower than inflation) and pushed them into riskier investments, particularly private equity. It helped private equity in a second big way not well recognized: a bunch of private equity deals should have gone bust in 2012-2014 due to weak companies needing to refi maturing debt then. In a normal market, the companies should have had to pay a big premium. They got off being able to refi due to prevailing rates being low thanks to the Fed and risk premiums also having fallen due to the desperate chase for yield.
By “helicopter money” I was thinking of the term in a loose sense as meaning giving companies taxpayer dollars rather then in a technical sense. My father made money from the stock market for a while. My impression was that his strategy was to buy the stocks of a distressed company and then wait for the government bailout. So the value of the stocks did not derive from actual legitimate accomplishments. Left alone the natural outcome for these businesses would be insolvency. So the bailouts made an enterprise that on paper should not be viable into a viable entity. My question then was basically whether “socialism for the rich” could make private equity viable and the answer seems to be “sometimes/partially”.
Even as a non-finance person, the reasons why PE is very rarely a good idea for investors are very clear to me and easy to understand (many thanks of course to Yves many previous articles on this) – what I like about the introduction to this paper is that it addresses so clearly and concisely why so many well paid professionals refuse to see what is right in front of their faces. A classic example of what happens when people are essentially paid a very big salary not to understand things.
I wonder though if this carapace of deliberate misunderstanding finally does collapse, what the result would be. If it becomes an embarrassment to have PE on your books (and surely that day will come for pension and investment funds), then how on earth can they unwind at a large scale without provoking a wave of looting by the rats leaving the ship. As so many PE high risk investments are likely to be exposed in Q3 this year as the real damage of Covid becomes apparent, we might just be about to find out.
I think one shouldn’t understate vlade’s point “the amount of cash they have to deploy is too large to deal with efficiently”
From the quoted abstract, the paper puts a lot of evidence of the returns from large public pension funds and the big 4 PE funds. Its seems clear to me that the problems of large investors and the managers who feed them derive on good part from trying to scale up an approach that just doesn’t scale very well and throwing more and more money at the same narrow group of opportunities. Like if there were 100 active public equity managers, 25 of them had 80% of the AUM and you spread your investment between all 25, then you would likely get the index return less fees. That may not completely invalidate nichier appoaches cannot be so scaled.
I can’t believe that any of the companies that fall victim to a PE takeover and restructuring can produce any sort of return to the “limited” investors beyond the disbursement of a small part of the initial looting. And I also find it hard to believe that PE is actually “private equity” – it always sounds like some big fat financial connection with revolving credit for insiders. Which sounds like it would implicate the Fed. And to interpret Floyd Blankfein’s comment about (providing the credit) doing “god’s work” is interesting as well – what good does all this looting do exactly? Most of the restructured companies are simply hollowed out and left wobbling in the ruins of an economy that itself has ceased to be productive and no longer functions. Shouldn’t all this baloney be legislated to be a crime; a class A felony; pure fraud? We need new resolution processes that prevent this piracy and simply provide a way to go out of business or scale back honestly. Something beyond an “energy bankruptcy” (RM’s suggestion) – but similar; like a future growth bankruptcy. If this were acceptable there would be no room for looting by “private equity.” And assets could be absorbed back into the system, not stuffed into the pockets of the oligarchs. Or is it already too late?
One thing that has always irked me is that Mitt Romney’s career looting other companies was never (surprise!) examined by the press. Did Romney help society or hurt society, so he could live the good life? The seed money for his company came from the sponsors of El Salvador’s death squads. This money was too toxic for other people– but not for Romney. Romney’s idea of due diligence was to meet with these people in a restaurant and allow them to convince him their actions were necessary.
This obscene behavior of Mitt does not surprise me at all. Thanks for the info.
There was a single excellent article by David Stockman:
It was a good article. What a circus. This sentence made me think of Boeing:
“The whole business was about maximizing debt, extracting cash, cutting head counts, skimping on capital spending, outsourcing production, and dressing up the deal for the earliest, highest-profit exit possible.”
Phalippou’s new paper adds an even more troubling conclusion: that since 2006, the economic benefit of outperformance of private equity was retained by the fund managers and not shared with investors.
How is this not like embezzelment in a new suit? A longish Galbraith quote from “The Great Crash of 1929″:
” To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in — or more precisely not in — the country’s businesses and banks. This inventory — it should perhaps be called the bezzle — amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.”
PE is still trading on a relaxed and trusting public, imo. Investing in PE has become conventional wisdom, a ‘no-brainer’ as they say.
Thanks for your continued reporting on PE and pensions.
A relaxed and trusting public or a combination of respectability (hi Mitt) and a glut of concentrated wealth seeking returns.