The ‘Inconvenient Fact’ Behind Private Equity Outperformance

After fees, investors in private equity funds earn exactly what they would have in public stocks, according to new research. But the high fees have not only created a new billionaire class, they’re squeezing private equity-backed companies for unrealistic growth.

(Brendon Thorne/Bloomberg)

(Brendon Thorne/Bloomberg)

Investors have paid hundreds of billions in fees to private equity managers over decades, minting tens of billionaires in the process — but for more than a decade, private equity returns have matched those an investor would have gotten by investing in publicly traded stocks, according to new research.

Ludovic Phalippou, professor of financial economics and head of the finance, accounting and management economics group at the University of Oxford Said Business School, made that conclusion in a paper entitled “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory,” to be published next week.

Speaking during a webinar on Thursday hosted by the International Centre for Pension Management, Phalippou said that from 2006 to 2019, private equity generated a multiple of 1.5 times, meaning investors received 1.5 times their original investment. A multiple of 1.5 equates to an 11 percent return — in line with public stock returns.

Between 2006 and 2019, large U.S. stocks as measured by the Vanguard S&P 500 index fund, CRSP Value Weighted Index, Fama-French U.S. stock market index, and the Fama-French U.S. largest decile index returned between 10.1 percent and 10.6 percent annually, according to Phalippou. Smaller stocks returned between 10.7 and 12.1 percent.

The MSCI World (annual returns of 8.6 percent) and Russell 2000 (8.5 percent) significantly underperformed U.S. benchmarks during the same period. But these two indices are the comparative benchmarks largely used by private equity since 2006 to show how the asset class outperforms, according to the professor.


“Once you understand this, you will understand everything you see about private equity returns and the discrepancies [with stock returns]. It all comes from a benchmark, not private equity returns themselves,” he said.

From 2010 to 2019, large cap indexes returned between 13.4 percent and 14.5 percent, matching the returns of private equity. Smaller public stocks returned between 14 and 16 percent.

Most non-U.S. institutions, however, invest locally, so the MSCI World index would be a good representation of their stock returns, which lagged the U.S. The performance of these global pensions’ private equity funds, which mostly represent U.S. companies, would then outperform their public equities.

Phalippou went on to explain the fee structure of the industry. In any given year the private equity industry invests $200 billion in equity from pensions, endowment funds, and others into leveraged buyouts, real estate, infrastructure, and other assets. Using the $200 billion in equity and another $400 billion in debt, general partners then buy private companies with a total enterprise value of $600 billion.

Using these numbers, he then argues that these companies are then stressed to the breaking point, because they have to generate returns large enough to overcome a total fee bill of about $100 billion, over an average holding period of 4.5 years, that investors have to pay.

He calculates financial intermediation fees of $100 billion — using an estimated 3.3 percent fee to acquire companies including due diligence, legal costs, and charges by general partners; 2.5 percent for payments to lenders, including bridge loans; and 5 percent fees to institutions that invest in everything from collateralized loan obligations to other private debt. The fund management fees and incentive fees themselves are another 25 percent. He cautions that the 5 percent in fees for private debt are the hardest to calculate, because the industry doesn’t publish statistics like the use of private debt funds relative to traditional banks and other lenders.

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The paper found that these companies have to generate 11 percent in annual organic growth to support the $100 billion in fees taken out. Earnings need to grow at 11 percent a year for investors to break even, he explained during the webinar.

For the past few decades, it has worked.

“Private equity returns after fees matched public market returns,” he said.

But he added that during the time period, companies didn’t need to generate 11 percent in earnings growth, because the price to earnings multiple was expanding, providing a tail wind.

“We know that the combination of increasing growth of multiples and organic growth has broken even,” he said. “You basically broke even over the last 10 to 20 years, but can this be repeated?” he said.

At the same time, the $100 billion in fees paid an industry of about 100,000 people. “That’s about a half million to $1 million a person,” Phalippou said.

From 2006 to 2015, the private equity industry raked in $230 billion in incentive fees, or carried interest, according to the research.

“This money went from companies and pensions to private equity fund managers,” he said. In 2005, there were three billionaires on Forbes list from the private equity industry. Last year, there were 17 private equity billionaires, according to the professor’s research.