Inconvenient truths in Private Equity

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Ever wondered why ** every single ** private equity fund has a since inception “return” of 26% annually? Looks great compared to c8-10% in the public markets n’est pas? Especially in an era of low returns! Private markets must be the way forward …

Yeah, nah, it doesn’t mean what you think it means …

It’s been almost 2 years since **that** paper blew up the investing / private markets press world and placed the author, academic Ludovic Phalippou at the centre of a mini-storm. We caught up with him on our podcast to quickly review the findings of the original paper and what’s changed since …

The quick tl;dr for those catching up is that comparing annualised returns when you have cashflows coming in and out of a fund (exactly like you do in a private markets closed end fund) is much harder than you think.

Where you have a nice public markets open ended fund which re-invests dividends you have the NAV at two points in time and you can then calculate your compound average annual return (or “CAGR”). You can compare that to an index, for example and your normal compound returns “math” works – ie if the figure is 10% per annum for ten years you can quickly and easily figure out what $100 investment will have grown to.

As soon as cashflows get involved, not so much, as Ludovic explains. I run through a lot of the details here for those interested, so won’t get into it again in this piece, but broadly you can get some very weird numbers coming out that don’t mean what you think they mean.

Now the funny thing is that I, like a lot of financial markets people who learned it early on in their career eg in exams I think kinda knew that the Internal Rate of Return (“IRR”) calculation had all these flaws and approximations yet it’s just so EASY to sort of wave your hands and assume it kind of basically, more or less, gives you a decent comparator and you get accustomed to it and stop challenging it. So for example if a private equity fund tells you they’ve done 25% per annum, compared to public markets at say 10%, you assume they have massively outperformed and that this is great. THIS IS NOT THE CASE! It’s completely possible that the return from that private equity fund is essentially the same as the public markets return – yet the reported return could easily be 15% higher.

Broadly if any of the following apply then the IRR number is not to be trusted:

  • IRR comes out high (>15% per annum)
  • You have a significant intial cashflow coming out early
  • You have cashflows close together
  • You have an early investment that makes a high return

The IRR can give answers that are compatible to a “normal” CAGR in some circumstances (as I show in that example) – for example when returns are steady and most of the payout occurs toward the end of the period, but often won’t, and most financial markets professionals just aren’t tuned into the difference. So we need to be a lot more skeptical than we are.

These markets have historically been unregulated, so there’s no restrictions on what PE firms can say. However as Ludovic says the SEC has proposed some changes to the governing of private funds, which cite his work.

Three important takeaways:

Insist on PME (public market equivalent) and MOIC (multiple of invested capital) as performance measures that will give a fairer picture … not perfect, but better

Prioritise investing in open-ended structures whenever you possibly can – these are simply better aligned with end investors, including for all the reasons noted above but not only for those reasons. In some areas like infrastructure, property and asset-bakced securities this is possible. In some other areas it simply isn’t, but don’t stumble into a closed-end fund if an open ended fund exists.

Fees. We haven’t really talked much about them but a big part of Ludovic’s work is picking through the private markets value chain to show what a staggeringly expensive way it is to deploy capital. In one example he estimates that to deploy £200bn in private equity “costs” c£100bn in costs, creating an enormous cost headwind for investments to overcome. But, fees in some private markets areas have come right down, for example infrastructure and private debt. Don’t get caught paying “2 and 20” when the real going rate may be less than half that.

Not saying private markets are a bad investment. In fact I think they can be great, just not as great as the superficial-level marketing and return numbers would have. Think carefully about why you’d want or need them in a portfolio and don’t default to some of the common lazy reasoning that often drives allocation decisions far more often than it should. I’m always amazed how asset owners/advisers will invest to chase say a 1% per annum “illiquidity premium” and then turn right around and pay almost all of that away in manager fees …

The “funny money” math of future expected return assumptions which drives a huge amount of asset allocation is particularly susceptible to the pitfalls of private markets: it’s easy to heap a nice juicy but vague additional return premium on, and essentially handwave away all fees by basically working in gross of fees terms without really being clear about it.

Sadly that often suits all parties involved as the allocator can claim a higher future expected return , so they look great (it’ll be a decade until anyone really checks the actual returns, if ever), and the private markets manager takes a large and sticky allocation and pockets some tasty fees. Not a co-incidence that so many private equity founders are billionaires.


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