A fool and his money are soon parted… The apple doesn’t fall far from the tree… We’ve all heard truisms such as these — mental models based on shared experiences that are so widely accepted and so ingrained in our culture that challenging their validity would be considered foolish. After all, truisms require neither proof nor support because they are, by definition, self-evident.
Truisms don’t just exist in pop culture; the investment management industry is replete with examples. Who among us hasn’t been told don’t fight the Fed or that nobody gets fired for buying IBM?
Now, a small but growing body of academic research has started to challenge yet another widely accepted investment truism: that private equity has been the best-performing asset class over the past decade. At risk are future asset allocation decisions across financial advisors, high net worth individuals, and institutional investors.
Have Private Equity Returns Mirrored Public Equity Returns?
One recent study that has sparked debate was published in June by Ludovic Phalippou, a professor of financial economics at the University of Oxford’s Said Business School. In An Inconvenient Fact: Private Equity Returns & The Billionaire Factory, Phalippou makes an unconventional case: that the investment returns of private equity funds net of fees have mirrored those of public equity indices from 2006 through the end of 2019.
Phalippou’s study finds that investors earned about $1.5 (net of fees) per $1 invested in private equity funds from 2006 through the end of 2019, implying a multiple of money (MoM) of approximately 1.5x. Assuming an investment period of approximately four to five years, this 1.5x MoM implies an annual return of approximately 11% — precisely in-line with the buy-and-hold returns achieved simply from investing in relevant public equity indices during that period. An annual return of 11% might align with investors’ long-term expectations for public equities, but it falls well short of the 20%-plus opportunity marketed to private equity investors. How can this be?
For some 15 years, Phalippou has argued that investors are presented with “misleading” performance information when it comes to private equity. He doesn’t suggest malfeasance, although he seems quick to highlight that there are few economic incentives to disrupt the status quo. His argument focuses primarily on the mathematical limitations of how investment returns are measured in the private equity industry, as well as what the appropriate benchmark should be.
What Are the Sources of Investor Confusion?
The most common measure of investment performance in private equity is internal rate of return (IRR), a calculation that is so institutionalized that industry reporting standards (GIPS) mandate its disclosure. Yet Phalippou repeatedly argues that “IRRs are not rates of return” (i.e., that what is presented as a net return is not the rate of return actually earned by investors) due to a fundamental flaw of IRR mathematics — the reinvestment assumption.
If early investments earn outsized gains, the IRR calculation automatically assumes that these early distributions will continue to be reinvested at unusually high rates of return regardless of whether those reinvestment opportunities truly exist. This in turn produces an IRR result that is implausibly high if it is being thought of as a rate of return that an investor actually earns.
The Yale Endowment, one of the most successful institutional investors in alternatives, offers an extreme illustration of the mathematical flaws of IRR. In 2017, Yale reported a 20-year IRR for its venture capital investments of an extraordinary 106%. However, an important footnote in Yale’s annual report adds key perspective: that the 106% return was heavily influenced by large distributions during the Internet boom of the late 1990s. Yale cautioned that it would be inappropriate to assume that it compounded the 106% annual return over 20 years because the mechanics of an IRR calculation assume reinvestment of those unusually high, early gains at the same rate of return for two decades.
The mathematical shortfall of IRR was even clearer in Yale’s 2019 annual report, which reported a jaw-dropping 20-year IRR of 256% on its venture portfolio. The starting point for this 20-year IRR aligns perfectly with the 1999 peak of the Internet boom during which the time between investment deployment and monetization was extraordinarily short. Given that tech stocks crashed in early 2000, Phalippou speculates that Yale’s venture capital IRR could drop to only 15% if the endowment retains the 20-year measurement period in its 2020 annual report. (He suggests that Yale could still report a high IRR if it switches to a since-inception IRR.)
Phalippou also applies this line of thought to several private equity giants’ annual reports. In effect, he suggests that the “big four” firms (Blackstone, KKR, Apollo, and Carlyle) benefit from a form of survivorship bias. (The big four, as well as the American Investment Council, all submitted rebuttals to Phalippou, which are contained or summarized in the study.) Each of these firms generated outsized returns in their early years and, because of the math behind IRR, they should all maintain unusually high “since-inception” IRRs. KKR’s IRRs underscore his point — the firm’s since-inception IRR has remained approximately 26% in the 12 annual reports since the firm’s IPO in 2007. Thus, a private equity firm’s early returns set the stage for many years to come.
Phalippou makes a similar case regarding Apollo’s IRR of 39% since its founding in 1990. He argues that this figure is “severely distorted” given the limitations of IRR; to illustrate, he highlights that a $100 million investment in 1990 that truly were to compound at a 39% annual return for 29 years through 2019 would be worth an impossible $2.3 trillion. Clearly, Apollo is not making this claim. Even still, KKR’s and Apollo’s since-inception IRRs will be the same in 50 years, assuming no major disasters, according to Phalippou. The math virtually guarantees a “sticky” IRR from outsized, early gains that can be marketed for decades.
The study also argues that the comparison between investment returns in public equities versus private equity is further obfuscated by a mismatch in benchmarks. That is, private equity returns are often benchmarked to global equity indices yet, by Phalippou’s estimation, approximately 70% of private equity is invested in North America.
Why is this significant? Cliffwater published a study that examined the investment returns of 66 large state pension plans. Per the study, private equity was the best-performing asset class over the preceding 10-year period, with an average return of 14.3%. However, when public equity returns were bifurcated between U.S. and non-U.S. investments, the U.S. portfolios returned an average of 14.7% — here again, inline with private equity.
Lastly, discontent with merely shouting the emperor has no clothes, Phalippou suggests there should be no emperors. During the study’s measurement period, the number of billionaires in private equity increased from three in 2006 to 22 at the end of 2019. Phalippou’s perspective is that a small number of individuals have benefited disproportionately despite delivering public-market-like returns. Perhaps that’s politics invading academia, but the point leaves an impression — much like a litigator might sneak a salacious question into witness examination, fully expecting the judge to strike it from the record. The jury is supposed to ignore it, but the zinger still lingers.
Nine Buyers for Every Seller of Private Equity as an Asset Class
Be this as it may, institutional investors certainly don’t seem to be complaining. Pitchbook reports that private equity’s annual fundraising soared five-fold last decade from less than $60 billion in 2010 to more than $300 billion in 2019. As it stands, private equity is now the most popular alternative asset class among institutional investors, with 65% allocated to the strategy according to Prequin.
Even still, investors are hungry for more. Of the institutional investors that Prequin surveyed (pre-Covid-19), 46% intended to increase their allocations to private equity while only 5% planned to decrease their allocations. That’s a 9:1 ratio. Think about it: there are nine buyers for every seller of private equity as an asset class.
Investors cite diversification and high absolute returns as the two most popular reasons for investing in private equity, with return expectations roughly 1.5x that of the next-highest alternative offering. Indeed, these expectations would seem to reflect the conventional thinking among many asset owners. But if such expectations are rooted in misinterpreted data, the consequences could be wide reaching if investors were to rethink asset allocation.
Phalippou is not the first academic to challenge the consensus view about the private equity industry, although he’s arguably becoming one of the most prolific; Phalippou has penned 28 research studies over the past 15 years that question nearly aspect of the industry, including performance, risk, selection, and regulation.
He’s also seemingly unafraid to add a little panache to the dusty world of academia. Described on Said Business School’s website as having an “informal and provocative” teaching style that is still “deeply tied to academic research and rigour,” Phalippou peppers his works with colorful titles: Beware of Venturing into Private Equity (Journal of Economic Perspectives), The Truth About Private Equity Performance (Harvard Business Review), and the best of all, Private Equity Laid Bare: A Myth-Debunking, Non-Boring & Never-Complacent Textbook.
Ludovic Phalippou says the emperor has no clothes. Private equity investors now have new fodder to evaluate old truisms
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