Beyond the hype: unveiling the realities and resilience of the private equity industry

During the 2018 US midterm elections, the Private Equity (PE) industry and its principals invested $150 million in various races, a figure they aim to surpass in the upcoming US presidential elections. A week ago, Belgian PE pioneer Jurgen Ingels, the founder of Smartfin, had the opportunity to interview President Obama at the latest edition of Supernova, an event that celebrates technology and entrepreneurship, held in Puurs. Gone are the days when they were derogatorily labeled as the “barbarians at the gate.” It’s clear now that the “private markets” industry has matured, earning respect from the broader financial community. Following David Swensen’s Yale Endowment model, institutional investors have significantly increased their investments in this asset class over the past decades. Today, Private Assets constitute a $5 trillion industry, comprising Private Equity, Private Debt, Real Estate, and Infrastructure. This article focuses on PE, evaluating the enthusiasm around it by comparing its returns with those of public markets. Additionally, we will examine the challenges the industry faces moving forward.

 

Returns: Lies, damned lies, and IRR

The conventional wisdom, supported by data from Cambridge Associates, suggests that private equity (PE) has generally outperformed public equities. The estimated outperformance, after accounting for fees, ranges from 3% to 4%. This assessment commonly relies on the Internal Rate of Return (IRR) as the metric for measuring PE performance. However, issues arise at this juncture.

First, IRR can be easily manipulated through the timing of capital calls and the use of leverage. Consider a scenario in which a PE firm purchases Company A for $100 on January 1st, borrowing nearly 100% of the funds, only to issue a capital call on December 29th and sell the business for $200 on December 30th. Such actions not only artificially inflate the IRR, thereby skewing longer-term return expectations, but also result in investors earning less than they would have due to fees and interest on the borrowed funds.

Second, comparing IRRs to the returns on stocks reveals a significant discrepancy. Unlike equity returns, which typically benefit from compounding—often hailed as the "eighth wonder of the world" by Einstein—PE returns are more akin to those of bonds, resembling a yield-to-maturity.

Third, a closer examination of cash flows reveals a more mundane reality than the industry might lead you to believe. According to Ludovic Phalippou in "An Inconvenient Fact: Private Equity Returns and the Billionaire Factory," investors have netted 1.5 times their initial investment in PE funds since 2006, after fees. This figure is roughly equivalent to the returns from public equity over the same period.

 

Cherry-picking a benchmark

Even if we can agree on the best performance metric for private equity (PE), the next question concerns the appropriate comparison benchmark. This opens up another complex issue.

First, geography matters. Often, PE funds benchmark their returns against the MSCI All-Country World Index. However, with 80% of PE deal flow occurring in the U.S., comparing it to an index with a 62% U.S. weighting tends to enhance relative performance, especially since U.S. stocks have strongly outperformed. Second, the size of the investments is crucial. PE funds predominantly invest in small- and mid-cap stocks, unlike the large-cap stocks typical of the S&P 500. When using only this measure and comparing PE returns to those of the Russell 2000, PE appears to have a clear advantage, especially as interest in publicly listed small and midcaps has declined. This benchmark, therefore, tends to flatter PE returns. Intriguingly, the Russell Mid-Cap Index has outperformed the Russell 2000 significantly, illustrating how choosing the correct benchmark can alter perceptions dramatically. Third, the use of leverage complicates comparisons further. Most PE transactions are "leveraged buyouts," which employ substantial leverage. It is, therefore, critical to consider this when comparing their performance trajectory with that of typically less leveraged publicly listed companies.

A recent paper discussing all the aforementioned points concludes: After applying these risk adjustments, no significant outperformance was found for buyout fund investments versus the public market equivalent on a dollar-weighted basis (François L’Her, Rossita Stoyanova, Kathryn Shaw, William Scott, "A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market," Financial Analysts Journal, December 27, 2018).

 

Fees: The Billionaire Factory

Antti Ilmanen, co-head of Portfolio Solutions at AQR, has highlighted that the all-in fees for private equity are exceptionally high. PE firms typically charge a 2% management fee and a 20% performance fee. When adding other less transparent fees, the total can reach 5-6% annually. Some argue that the total expense ratio (TER) can be as high as 7%. This sets a high-performance hurdle compared to e.g. an active equity fund, which charges roughly 1 tot 2%.

In a highly critical paper titled “An Inconvenient Fact: Private Equity Returns and the Billionaire Factory,” Oxford professor Ludovic Phalippou focuses on U.S. PE. He starkly points out that deploying $200 billions of equity, the typical volume for leveraged buyout (LBO) deals, necessitates upfront costs of $100 billion. He depicts the industry as a mammoth entity employing roughly 100,000 people, supported by an extensive ecosystem of consultants, advisers, accountants, and lawyers. These professionals perform due diligence and levy fees at every stage of the investment process, from acquiring the target company to debt financing and equity raising.

Phalippou also critiques the performance fees, known in the industry as “carry,” which are fees earned on returns that exceed a certain hurdle rate. He identifies two main issues: first, investors must pay carry on successful investments but cannot recoup it on unsuccessful ones; second, carry is calculated as a fraction of absolute performance rather than relative performance. Considering the returns mentioned above, investors end up paying significant performance fees, in addition to a myriad of other charges, for performance that does not surpass that of a cost-effective index fund.

Much of this revenue accrues to a relatively small number of individuals, primarily founders of large PE firms. From 2005 to 2020, the number of PE billionaires increased from 3 to 22. The biggest beneficiaries have been the founders of Blackstone, Apollo, KKR, and Carlyle — the four largest private equity managers. According to the annual Forbes list, Stephen Schwarzman of Blackstone, with a personal fortune of $17.7 billion, is the world's 29th richest billionaire. Leon Black of Apollo, with $7.7 billion, ranks 63rd, while George Roberts ($6.1 billion) and Henry Kravis ($6 billion) of KKR are the 108th and 112th richest billionaires, respectively. David Rubenstein, co-founder of Carlyle, is in 275th place with an estimated wealth of $3.1 billion.

 

An illiquidity premium, or a discount?

Investors in private equity typically commit their capital for a period of 10-12 years, during which, unlike in public markets, they cannot sell their stakes. The prevailing belief is that they should be compensated for this lack of liquidity with higher returns. However, as the discussion above illustrates, this expectation often goes unmet. Yet, investors have continued to invest heavily in various PE strategies.

Exploring this phenomenon, Clife Asness of AQR has reached a remarkable conclusion: illiquidity should be seen as a feature rather than a flaw. As he articulates: “Liquid, accurately priced investments let you know precisely how volatile they are and they smack you in the face with it. What if many investors actually realize that this accurate and timely information will make them worse investors as they’ll use that liquidity to panic and redeem at the worst times? What if illiquid, very infrequently and inaccurately priced investments made them better investors as essentially it allows them to ignore such investments given low measured volatility and very modest paper drawdowns?”. (Cliff Asness, December 19, 2019, "The Illiquidity Discount", https://www.aqr.com/Insights/Perspectives/The-Illiquidity-Discount).

Through this reasoning, investors are willing to pay a premium for strategies that allow them to smooth out returns and avoid the pitfalls of market timing.

 

The future: lower returns for buy-outs and the golden age of private credit?
With assets under management (AUM) totaling $ 5 trillion and $ 2.6 trillion in assets ready for deployment (pre-leverage), the private assets industry is firmly entrenched. Warren Buffett has noted that an increased supply of capital pursuing a limited number of quality businesses available for sale is likely to diminish returns in the future. Additionally, several tailwinds that previously buoyed the industry have either vanished or reversed direction. Rising interest rates have made debt more costly. Particularly in the U.S., valuations are high. The challenges of exiting investments have grown in a climate marked by a drought in IPOs and deal flow. Furthermore, with globalization retreating and labor markets tightening, restructuring businesses could be more complicated than before.

 

As Marc Rowan of Apollo highlighted, “if Private Equity firms would be forced to go back to investing the old-fashioned way. They’ll actually have to be very good investors” (Financial Times, “Apollo Chief warns private equity industry 'in retreat' as rates rise,” August 3, 2023). However, the industry's track record in this regard is mixed. A recent report by consultancy Bain & Company on the industry notes that, despite claims from private equity firms of enhancing the companies they acquire, “nearly all the value creation in private equity-owned companies between 2012 and 2022 actually came from revenue growth and multiple expansion. Margin expansion barely registers.”

The scenario of sustained high interest rates, coupled with banks adopting a more cautious lending stance, may, in fact, benefit a particular niche within private assets: Private Credit. Celebrated as a significant shift in the way credit is provided to businesses, Private Credit is viewed as highly complementary to the traditional banking system, offering a source of capital that is long-term, as opposed to the more volatile nature of bank balance sheets.

 

Beware the smartest people in the room

As we've observed, investing in private equity doesn't necessarily yield superior returns compared to listed equities and comes with a hefty price tag. So, why do people invest in it? First, as previously mentioned, investors may be willing to pay an illiquidity premium and accept lower returns to avoid making hasty decisions to sell during market downturns. Second, PE can offer diversification benefits. PE, especially outside of Venture Capital, often focuses on sectors currently underrepresented in major indexes. In the US, it provides diversification away from Technology. In Europe, it offers alternatives to Oil & Gas and Banks. As the pressure to adhere to benchmarks intensifies in liquid markets, PE might offer an escape. However, there's a third reason, as discussed by Morgan Housel in his podcast (The Morgan Housel Podcast, Spotify). He suggests that investors are often attracted to "complexity" rather than simplicity. In their view, a PE fund, accessible only to professional investors and managed by top Harvard and MIT MBAs, using intricate valuation models and hiring the best lawyers and consultants, must outperform a straightforward, low-cost index fund available to everyone.

Currently, the PE industry is launching more semi-liquid strategies, increasing fee transparency, and actively lobbying to open up to retail investors. Ironically, this could diminish their appeal as both the illiquidity and sophistication premiums wane. Meanwhile, we will keep trying to spot the customers’ jets.