Episode 210: Prof. Ludovic Phalippou: Private Equity, Under the Hood

July 21, 2022 Guest User

Ludovic Phalippou rides road bikes, routinely tastes great wines, works (a bit) on food-waste reduction, forests (carbon captures) and diversity/inclusion initiatives. In his spare time, he is a Faculty member of the Said Business School at the University of Oxford, and heads the Finance Accounting and Management Economics group. He is also a Fellow at The Queen’s College, and sit on both its investment committee, and its wine committee.

Over the last twenty years, he has been actively researching the private equity industry. He published about ten articles in leading academic journals on the subject; they have been downloaded 100,000 times and cited more than 3000 times. This research has also been presented in over 100 universities as well as at major academic and practitioner conferences around the world, and featured in the media internationally (including The Economist, Financial Times, The New York Times). He has been teaching private equity for ten years to MBA/EMBA students, and developed a variety of executive education courses, including customized programs for leading consulting companies and asset managers. Besides some teaching awards at the University of Oxford and University of Amsterdam, he has been honored to be named as one of “The 40 Most Outstanding Business School Profs Under 40 In The World” by the business education website Poets & Quants in 2014. In 2016, realdeals magazine listed him as one of the 20 most influential individuals in private equity in Europe – the only academic listed. Finally, he stayed at school for a long time, ending up penniless but full of degrees: Bachelor in Economic Engineering from Toulouse School of Economics; a couple of Master degrees (Economics, Mathematical Finance) from the University of Southern California; and a PhD in Finance from INSEAD.

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If you have any interest in private equity or have thought about it as an asset class, then this episode is for you! What is private equity? This might seem a simple question but the answer is more complex than you think. Private equity is a nuanced subject that requires a deep understanding to make successful investments. To help unpack this non-trivial subject is expert Ludovic Phalippou, a Professor of Financial Economics at the University of Oxford Saïd Business School. Although he studied economics in general, his research mainly focuses on unravelling the complexities of private equity. He has written many papers on the topic, including a book called Private Equity Laid Bare. He has a Masters in Economics and a Masters in Mathematical Finance from the University of Southern California and a Ph.D. in Finance from INSEAD, making him well versed in the subject. Besides his impressive qualifications and experience, his insight and ability to speak to the data make him stand out from other experts. In our conversation, we get into the basics of private equity and what makes it attractive to investors. During our conversation we discuss the challenges for measuring performance, how to best measure the performance of private equity funds, the different facets associated with private equity, how to tell if certain private equities are a good investment, and the differences between private and public equity. We also hear how it is applied as he walks us through some real-world scenarios and gives us some insider knowledge on the best private equity options. As you will hear from our conversation, there is no easy answer!

Key Points From This Episode:

We learn what asset classes are included in the broad term of private equity. [0:03:39]
The end-to-end process for investing in a typical private equity fund. [0:06:49]
The challenges with measuring the performance of private equity managers. [0:09:48]
How investments that have not yet been sold are treated when a manager is reporting on their performance. [0:12:48]
Professor Phalippou explains how well the IRR captures the economic results delivered by a fund. [0:14:04]
Whether there are alternative approaches to evaluating performance. [0:17:52]
A discussion about the typical characteristics of a buyout fund. [0:19:35]
The best approach for evaluating your private equity. [0:21:24]
Find out if a public equity benchmark has to be adjusted for leverage, regarding buyouts. [0:24:26]
We learn about the fees that private equity limited partners typically pay. [0:26:34]
Outline of the less obvious fees that limited partners might be paying. [0:28:11]
Whether an investor paying carry is a sign that the investment has done well. [0:31:07]
Comparison of private equity performance relative to public equities. [0:32:31]
What number Professor Phalippou would assign on an expected return to private equity, as an asset class. [0:38:46]
How successful investing in private equity has been for institutional investors. [0:39:32]
The performance of Blackstone and KKR is discussed relative to an average private equity fund. [0:42:11]
We get details about the Yale situation and how it manifested. [0:44:24]
Reasons why private equity is regarded as the best performing asset class for institutions. [0:45:32]
Professor Phalippou tells us if he thinks private equity offers diversification benefits to a public equity portfolio. [0:46:01]
He discusses a recent case study regarding Hilton. [0:47:11]
Why he thinks sophisticated investors are allocating funds to private equity. [0:48:14]
Professor Phalippou shares how to be successful when investing in private equity. [0:50:00]
Whether the returns of private equity can be replicated in public equity. [0:53:09]
How Professor Phalippou defines success. [0:55:18]
We end the show by finding out if the value premium is risk-based or behaviour-based. [0:55:35]

Read the Transcript:

I'm very excited to be talking to you. To start, can you tell us what asset classes are included in the broad term 'private equity'?

So in my book, I spend most of the first chapter just trying to explain what the different terms mean, because it means... It's used in different ways by different people. So technically, private equity is anything that is private and equity. So it's kind of the complement of public equity. So public equity is any equity that is open to the public, which means it's what you get on stock exchanges all around the world. So private equity, technically, it's everything that is equity, but you cannot access publicly. So my dad had a bakery. The equity in that bakery was private equity, right? My mom had a farm, it was private equity. So all of these would be technically, private equity. Now, when usually people talk about private equity, they don't talk really about all the equity that is private. So what they really talk about is what I called in the book Institutionalized Private Equity.

So it means that there is an intermediary that institutionalized that space like the bakery of my dad was not... nobody was invested in it except him. So institutionalized private equity is when you have some third parties coming in. And so, it can be a family office, it can be a pension fund doing it directly via funds, via funds of funds, then funds. So there are some intermediaries and there is a line that is pretty blurred. So for example, you can have a family office. Imagine that my own money is being managed by a professional and these people then buy a bakery. Is that then institutionalized private equity or not like? It's kind of my own money. I'm just investing in a bakery. Yeah, I own it fully, hundred percent me. What's the difference between that and just when my dad was owning his bakery? But because I would go buy an official family office or go official as an unclear within registered family offices, it would probably fall under institutionalized private equity. People would see that as private equity.

So you have this institutionalized private equity, but sometimes within that, people for some weird reasons, when they talk about private equity, they mean only leverage buyouts. And money is very strange because there is absolutely no rationale for doing that. So sometimes when people say, "Oh, you have venture capital and you have real assets, and then private equity." And you're like, "No, let's leverage buyouts." All the other things you mentioned are private equity. And sometimes people also put private debt into private equity, right? Which is you shouldn't do. So then we should call it private capital or private markets. So there's a lot of confusion about vocabulary. So this question seems trivial, but it's actually quite complicated, I'm sure, but the answer was longer than I'd hoped for.

No. No, that was perfect. So when we're talking about private equity data, we're going to ask you a bunch of questions about that, are we talking about everything or is it VC, or is...?

Yeah, my specialty is leveraged buyouts. So I tend to comment most in leverage buyouts. Most average buyout is American. This is also where we have most data. So most of what I've worked on and things we will talk about will be American leverage buyouts, really.

Okay.

But we can try to specify it.

So what is the end to end process for investing in a typical private equity fund?

So if I am the one raising money and if I'm the fund manager, I will need to have some sorts of track records. I cannot just raise money just by showing a nice CV. So you would need a track record in investing, and then you can raise a fund. If you don't have a fund, then there are some other ways. You can do some consulting first or you can do deal by deal and things like that, but let's say it's a fund you're raising. So if I'm raising a fund, I present this track record to a number of investors in a so-called road show like you would for normal IPOs or anything else. You go a road show. You may be with a placement agent to help you or doing it yourself. And then you're going to see some institutional investors, or you can even be individuals that are rich enough to invest.

And then you are going to have a limited partnership agreement that they're going to sign. And what that involves all them is that they are going to give you the equivalent of a credit card. They're going to say, "So, if Benjamin wants to invest in my fund..." He's going to say, "Okay, I commit to you 50 million and you have five years to draw it." So it's as if he gave me a credit card with 50 million on it. And during the next five years, I just draw it when I want to, but going back to then what we just discussed, this is very much a leverage buyout fund. So venture capital fund, maybe the credit line lasts for 10 years, so the commitment will be for 10 years. It's a private debt fund. You'll be more for three years. Real estate would be sometimes a bit closer to three as well than five.

So you would have some idiosyncrasies that depends on the type of investments, but basically, you would have this commitment, which is a very important thing. You have a deadline and you have a certain amount of money you can draw from institutional investors, and then you can invest pretty freely. Usually, you try to do what you said, but you invest this money and then you hold the asset three to five years and return the money when you exit the asset. So usually if it's in a fund, we're going to invest in about 20 things. And each time I exit one, I give the money back. So it is called a buy to sell model. I'm buying stuff in order to sell.

That's very important because it's a very different mindset than a Warren Buffett or a usual mutual fund, etc. In private equity, the deal is that I'm approaching Benjamin and I say, "Look, I'm a specialist of French bakeries. I know how to consolidate bakeries. I know how to speak to bakers and I can make bread better than anyone else." And then he will say, "Okay, so let's do that then buy a number of bakeries and similar things like maybe Chocolateries or things like that, and I'm going to deploy this strategy, but each time I get into a bakery, I have a plan to make this bakery worth more and execute that plan. And I try to sell it as soon as possible once people can price in the fact that I've made it worth more." So, that's a model that I'm coming in to make an asset to have more. As soon as we have more and I can exit it, I do and I return the money to Benjamin.

Okay. So you mentioned the fund manager, hopefully, having a track record that they can go and sell. What are the challenges with measuring the performance of private equity managers?

So, the challenge is that when you have an asset that is non traded continuously, we don't know how to measure a rate of return. And people are very much used to that. They say, "Oh, if I invest with you, are you giving me 10% or 20%?" Right? And that doesn't exist in a private investment and the reason is pretty simple. I can give you as an example, imagine that I buy a house with your money for $1 million and I sell some of it or some rights to it for a million three years later. And then I sell all of it for another 2 million eight years later. What was my rate of return on this investment? It's actually not possible to calculate it. You would need to have only one cash distribution and one cash investment to calculate the rate of return. So the rate of return doesn't exist.

So when people come up with some kind of shortcomings, and so that leads to all kind of abuses because there is no measure of rates of returns. Even for measures that are simpler called multiple of money, which is how much you gave me back compared to what I gave you, even that can be manipulated in different ways. And because there are no rules in general, you can do all kinds of things. So for example, you mentioned, I worked at KKR and I worked on a number of deals. Some of them, I did the Excel spreadsheet and some others, I was in the investment committee, but didn't say anything. On some other ones, I did say something. So when I did the Excel spreadsheet, that was kind of influential. So I can define involvement the way I want. And then when I go to raise money to investors, I say I was involved in four deals at KKR.

Nobody can check. So I can just take four amazing deals at KKR and I wouldn't lie. I was kind of involved in all of them, right? But I'm quite free to define what is it I was involved with, right? So you would have all kinds of things like that. I can raise money. I can have, let's say, made 20 investments in the past, 10 of them were successful, 10, not, and I can tell you that going forward, I want to invest in hospitals in the U.S., and this is my track record relevant for hospital investing in the U.S. Well, yeah, it just happened to be my 10 investments were in that space and I'm just not telling you that I tried something else and it failed, like maybe I invested in Asia and it didn't work.

I'm never lying because that would be very problematic, but I'm not giving the full picture. So the problem when you have no rules is that it's the wild west, right? It's very hard to assess a track record of someone. So, of course, you will have some diligent investors that will do phone calls, that will try to call the previous guys that were in the funds saying, "What the hell did this guy invest into? It's a bit weird. He said he has 10 investments, but he had raised the fund. It was bigger than that, so how did it work?" And even with what I was just alluding to about performance track record, you could have probably obtained the full cash flows and tried to reconstitute things and so on, but it's never going to be really trivial. It's not like when you have a Morningstar that gives you the stars of mutual funds and the track record where everything's standardized, you can compare across funds, and so forth. You would not have that, so it's tricky.

Hmm. So you mentioned the buy to sell model. How are investments that have not yet been sold treated when a manager is reporting on their performance?

Yeah. So that's another thing, right? So if an investment is held for five years and you have five years to invest, roughly, once you are reaching your year three, two, you need to raise a new fund, right? Otherwise, you're going to run out of money. So every two to three years, you're going to raise a new fund, but after two years, maybe you have exited one thing if you're like extremely lucky and then the rest is not realized. Even when you raise your third fund your year five or six, you may have one or two exits, but you have fully invested one fund, while the rest is probably over 18 investments. You don't know of the value.

Even at form four, you still have quite a lot in the portfolio. And in fact, as you grow, you have some realizations that they get older and older, and the bulk of what you have is unrealized stuff. So what makes it difficult as well to assess a track record is that most of what you presented is usually un-exited and it's a private investments so we don't have an official price for them. And it's the person raising the money, but he's telling you what, in his or her opinion, things are worth. So, but obviously, the flag is red, right?

Okay. Now, we've seen lots of private equity pitches and you always get the IRR. How well the IRR is capture the economic results delivered by a fund.

So, the IR is one of the shortcuts I was talking about earlier. So there is no way you can measure a rate of returning of fund. So the IR is making an assumption to give you a number. And that assumption is pretty... We can describe it mathematically if you're interested, but it's actually very complex. So like the example I gave you earlier of the free cash flows by hand, and I have a math degree, I cannot calculate the IR, okay? It's very complex. So Excel does it. It's a code, it's a loop, but Excel calculates to calculate an IR, etc. So it's pretty demanding as a calculation. And basically, the way the IR is sold is that this, assuming that anything that has been observed in between in terms of cash flow has been reinvested at the rate that the IR says or is.

And so this is how you manage to boil down to two cash flows. Again, you can calculate the rate of return if you have only two cash flows. So the IR, what it is solving, basically saying, if I put all the cash flows and I reinvest them at the rate of X, how can I end up with a rate of return? That is the same as the IR, right? So you have one equation into a known. So you say each unknown, they would be equal, what would be the answer. Right? So you can solve that, but not by hand. So the short answer to the question is when you see an IR that is below zero, it's actually never shown. You can see that they have lost money and they were not meaningful neck instead of the IR, and they are correct.

The IR is not meaningful because what you would assume is that each time they distributed you money, you burnt some of it every year, right? Because if IR is negative, it means that every year, you get a negative rate of return on your investment. So somebody gave you a hundred million dollars. If I's minus 10 every year, you just burnt 10 million out of his pot, right? This makes no sense. So people are right. They never report a negative IR. They say it's not meaningful, and they're correct. It exaggerates with bad returns, but for very same reason, any IR above 15% is not meaningful because there is no way you would ever invested the money at more than 15%. So most of the IRs you will see have like 30%. None of these numbers are meaningful. So this is usually because in the beginning of a fund's life, somebody has made some good deals.

Otherwise, they die. They stop raising money.

Right.

So at the beginning of somebody's track record, it's always good by definition. And so this is assumed to have been reinvested at a very high rate, which then gives you a stupid answer. And you end up in situations like what I've pointed out where KKR, since they are publicly listed in 2006, every year, they tell you they have 26% IR. They don't even call it IR. They say we have 26% annualized performance since 1976. And you say, "That's amazing" because from 2006 to today, 16 years and every year you have 26% since 1976. It's extraordinary. The reason for that is that they were 26% in the late 70s, but this amount we have distributed is supposed to have compounded at 26%. And if you compound something at 26% for forty years, it's worth trillions. So then it is assumed that these dividend that KKR did distribute in the late 70s are worth nowadays trillions.

And so no matter what KKR does in terms of real performance over the last 10 or 15 years, you're supposed to be sitting on trillions. So it doesn't matter. And that's why then the performance doesn't move. So the IR does all kinds of weird things, but if you want to have a simple rule of thumb, when you see an IR presented to you, if it's a number between two, 3% and 12%, go for it. It's fine. It gives you an idea of what the rate of return was. If it's outside of this range, then it's very tricky. You need to look very closely and more often than not, it's going to be a stupid number.

So are there alternative approaches to evaluating performance?

So, none that would give you a rate of return, right? Because again, the problem is if I have separate cash flows, more than two cash flows, I don't know what the rate of return is. I suspect that before the advent of continuously trading assets, people didn't think about the rates of return. I was not there in the 17th century, but I'm pretty sure that people would talk about things like you can double your money in eight years. So things like that, right? And it's really since things are continuously traded, but people then compounded to daily frequency, weekly frequency, monthly frequency, they're now thinking only in rates of returns. And they find it difficult to think, "Okay, is doubling my money in eight years a good deal or not?" So the closest guarantee that they are advising like in the textbook is to use net present values or present values.

And so present values, you have this public market equivalence, which is a ratio of present values that academics tend to use. That's a lot better, but now, what we see people doing in practice is that they call public market equivalent. It's things that are like differences between IRS and they just call it public market equivalent because they say, "Oh, you've been told that PME, public market equivalent, is the right thing to do. So I did a difference of IR and I'm going to call that PME, so then I should be good." I'd be like, "No, you're not good. This is basically an IR. Go back to the normal way of defining present values." So yeah, we have better ways, but we don't have an ideal way. And that's why the bad way persists is because we don't have an ideal way.

And is there any standardization? You mentioned the Morningstar analogy, is there anything like that in private equity?

No. No.

Huh. Okay. Within the holdings of a, say, a bio fund, what are the typical characteristics? If we were to use public markets as an analogy, what's the company size, relative price, all that kind of stuff?

Yeah. So if we are U.S. leverage buyouts, we are talking mainly about something that would be a Small-Cap and that used to be a value stock in the 2000s and 90s, 2000s, but the last 10 years, you'll be a growth stocks. So what has been incredible with we've leveraged buyouts in the U.S. is that in the last 12 years, one third of the deals were in softwares. Just software alone, one third of a volume of buyouts in the U.S. Right.

Wow.

If you still open any textbook, they will tell you, in a buyout, we take an industrial company, we make it better. Or we take an analogy Nabisco, we break the conglomerate. It will always be stories about companies that are cash rich and badly managed. And you take them over and you manage them better.

In the last 12 years, you get software companies and all kinds of tech companies and bio techs and you do mergers. You do a lot of M&A activities on that. So it's a very different type of investment. So in the U.S. leverage buyout, small value for the 90s and 2000s, small growth over the last 12 years. If it's outside of the U.S., it tends to be growth equity. So it tends to be much less debt and it tends to be then meet cap, and again, growth companies. You wouldn't get much investments in value companies outside of the U.S. And outside of the U.S., it would be fast growing companies in which you inject equity to make them grow faster.

That's why also outside of the U.S. and the UK, the e-merger private equities are also a bit different and it's not quite the same kind of investment. So it's country dependent, but also, type of asset dependent. So a venture capital, yeah, Small-Cap NASDAQ probably will be close to that in the U.S. Outside of the U.S., you wouldn't really have an equivalent. So there are many subcategories that do not have equivalents as well.

So how does one choose the best benchmark for evaluating your private equity?

Yeah. So that makes it easy in the U.S. leverage buyout, because you could say, "Well, if I don't want to do value versus growth tilt, at least if I do a Small-Cap, Mid-Cap public equity, I should be in the ballpark of okay with leverage buyout U.S." And I think that's fair enough and that's fine. I think that leverage buyout is so big in the U.S., compared to venture capital and the rest, but even if you said all of private markets U.S., or these private market funds, you include venture capital and real assets and everything, and I would benchmark against Small-Cap, Mid-Cap, U.S. top market index, you will probably still be about all right. When you go out the U.S., you cannot do that. You have to go fine tune tremendously.

So for example, if you were to do it in Europe, the main European publicly listed in indexes, 15% are Swiss stocks, 15% are banks, 15% is food companies. Another 15% is oil gas. There is no way that private equity investments in Europe are 15% in Switzerland and this proportion across the different industries I've given. It's actually zero in Switzerland. Near zero in Switzerland and near zero in all three industries I just gave. And that would be already like half of the European public equity landscape. So in Europe, if you want to benchmark private equity, you really have to go and develop all the country, country by country and try to find the best possible match in terms of industry, but you would have difficulties because even if you do that, it would be a great progress, but it would still be difficult because imagine that most investments, again, public equity in France, Spain, etc., it's going to be more tech focused.

It's not tech companies that are not listed on this countries. And then if you start going to other geography, like even China, where private equity is massive and it's mainly venture capital, there's not much Chinese stocks to compare it to. And then you can go to countries as well where there is hardly any public markets and you will have some private equity activity. Take even the all of African continent, there's quite a lot of private equity activity compared to stocks listed. So you certainly won't have any benchmark.

Yeah. That's super interesting. So it's not just the characteristics, it's also the sector mix of the benchmark that can affect it.

It's been very important because the last 10 years with tech going through a roof and during the COVID as well with tech and healthcare going through the roof, this is exactly the two industries that private equity was massively invested in. The other firm was roughly leisure. And so that, they got negatively hit by... But if you don't take into account the sector composition, you get it completely wrong. Especially with the recent movements, it was really less sector dominated. 10 years of huge increasing prices for tech accelerated during the COVID. And right now, the crash that has happened over the last six months is mainly tech stocks being dumped and value companies doing well. So, the industry has been a key driver of returns.

Wow. What about leverage? If we're talking about buyouts, do you have to adjust a public equity benchmark for a leverage?

It's tricky because when people do that, they use a formula, which is basically if I had borrowed money to invest more public equity, I would've got higher return on average. Yes, but it's like buying stocks on the margin. And then if you simulate any sub strategy, you would've been bankrupted five times or 10 times over the last 20 years. It is totally not trivial to just lever a public equity. And private equity does use a high amount of leverage, but leverage is structured in such a way that is fairly robust. So I wrote a case study on Hilton hotel, for example, where Blackstone gets Hilton hotel private, Hilton hotel is valued by the stock market at $20 billion right before Blackstone takes it over, and Blackstone borrows 20 billion that they put on Hilton hotels as debt. So imagine that. The company like Hilton hotels gets debt to pay that is 20 billion.

And that's what the market was saying. This is the value of the entire thing, and that's on their book. And then they get hit by 2008. If it could have put half of its debt and they would've been wiped out. And of course, they're were in bankruptcy a year later. And Blackstone manages to convince people that they know how to run a hotel, but lenders do not. It's a very big company, it requires specific skills. So, Blackstone managed to stay in control even though they were bankrupt and actually ended up making money on the investment while the debt holders lost some. And so you end up making a return, while if you would've just leveled up Marriott hotel, you would've been bankrupt.

Interesting.

Even if you would've leveraged it just 20% instead of 80%.

Yeah.

So you cannot really compare the two leverage. So when we try to estimate from the cash flow patterns what kind of better is most consistent with these patterns we see, it's not quite what would be the equivalent of very high leverage in public equity, but it is a better of 1.3 up to 1.5 in certain studies. So you should adjust for the extra risk for raising leverage buyout, but it's not as much as what people usually think.

Interesting. What are the fees that private equity limited partners typically pay?

So, I estimated them at about six to 7% a year in leveraged buyouts, which is by far, the highest of any sorts of assets. It's probably more like a 5% in venture capital or 4% in real estate infrastructure, three, three and a half for private debt, etc. So it's going to depend on the exact products and so less in emerging market private equity funds, but most of the money goes into U.S. leverage buyout funds and this is about six, 7% a year historically. And it's important to know that we don't know the exact answer because nobody has ever disclosed the fees that they have paid on the investor side.

They have always disclosed them only partially, even to this day. And the fund managers do not disclose really their fees, even if now, there are some that are listed like KKR and you try to go through their revenues and so on, you would have difficulties to reconstitute how much per dollar are invested on the management is being charged because they always have money, but they haven't invested yet, but on which they get fees. And so it's always quite difficult, but a six, 7% estimate seems to be in the ball park of reasonable. It's easy to also reconstitute this number intuitively given the typical fee structure. It is never the number that is recited, and I think that it should be. Yeah.

Wow.

It's a high number.

So, many investors aren't aware of what those fees are?

No, not at all. And if you go by your funds of funds as well, and then it's even more. No. People do not translate it this way. They will say, "Oh, I just pay the normal to 20." But they don't translate that into, "Okay, but what does that mean?"

What are the less obvious fees that an LP might be paying?

For example, when a fund wants to make an investment, they don't call the money from you like we said we would. Instead I'm going to borrow the bank money. The reason I do that is that then I can gain a bit my IR, because if I don't call the money at the beginning of the fund's life and I wait until some exits are very close to that, I will recreate this illusion that I made an investment, got some money quickly back in, so it gives a higher return. And we're going to assume it's going to be reinvested at this very high rate and the IR would go through the roof. So for example, if I borrow money at the bank instead of calling the money from you, all the fees of the bank are going to be paid by you and you won't see it because I'm just going to call a bit more money next time and take some of it to pay the bank.

So, that's the sorts of things you wont to see. Something else I may do is that with your money, I bought an apartment and I'm collecting the rent for you, right? But there is a week, I say, "Look, I did some consulting work on this apartment. I looked around and I changed the decoration, things like that, and I'm going to just keep the rent for the next three months for consulting fees. And so I decide that I should pay myself consulting fees because I worked on this apartment." It used to be the case that investors would not see it at all. I did a lot of work on this, so now they're more aware of it and they didn't seem to ask for more information about this. They are obtaining some of it. Some of it, maybe not fully, but these are the sorts of non obvious fees that people would pay.

So the first one that they gave as an example is a fund expense. The second one is an example of a portfolio company fee. And then you have even less obvious things which would be, imagine that my firm specializes in controlling hotels. So with your money, I buy hotels, but my sister and I decide to create a company that buy mattresses and sell them to hotels. And it just happen that all these hotels I control buy their mattresses via the company of my sister and I. And because we buy a lot of mattresses, my sister and I buy the mattresses for $10. We sell them back to this hotel for $20. Of course, $20 is kind of like a market price if a single hotel was buying a mattress, but I bought a lot of it. And if all these hotels would've got together and bought the mattresses, they would've got it for 10.

So then it's kind of gray area, right? So it's not like an obvious fraud. I'm not overcharging the hotel, but I'm doing bulk buying and use the fact that I'm controlling different companies to make money personally. So then indirectly, Ben, your money went into the hotel who's paying $20 for the mattress. I could have arranged things differently and you would've paid $10 for a mattress. So then you pay more cost than you should have had, then this is money I'm taking away from you, but is going to my sister and I.

Wow.

So it's really probably the less obvious fees.

Yeah. That's very, very unobvious. What about carry? Like you mentioned two and 20. So you've got a performance fee in there. If a private equity fund does well and the investor, the LP is paying carry, does that mean that they've done well on the investment?

Yes, but people who have traded options, no. But it's very tricky to judge options one by one. So you can very well have in a portfolio, half of your funds that did well and half of them that did badly. The one half of did well, you give them 20%. The ones who did badly might have underperformed by as much as the one who did well, but if you end up having paying carry and having a portfolio that's not doing very well. Right? So when you get options on individual assets, it's quite costly compared to having an option on the basket, right? So a basket of options is a lot more costly than an option on the basket. So most people don't see that very well. They don't have that intuition.

So a purely carry sounds innocuous. They take 20% if they do well, but imagine that you have a hundred monkeys who get 20% carry and random investments in stocks for you. You will say, "Well, I've paid only the monkeys that did well." Sure, but overall, you go to the market portfolio and you ended up paying 20% to whichever half of the monkeys were lucky.

Right.

So, one needs to be careful with that. The carries are symmetric and that creates issues at the portfolio level.

Okay. We've talked about the structure of funds and the process to invest and all that kind of stuff. The challenges with measuring performance. Given all that, what do we know about private equity performance relative to public equities?

So, that caveats first that this is a past and it's more important to think about the future, but it's good to have an idea of the past, but we should certainly not make investment decisions based on past returns. We know there is no relationship, but people keep on just being very obsessed with past and track records. So in a nutshell, private equity in Europe has done much better than public equity in Europe, but the industry mix is completely different. So if I just tell you that public equity in Europe is banks, oil and gas, and things like that, and tell you they underperformed a portfolio of tech firms in Europe over the last 15 years, that shouldn't come as a surprise, right? So we don't know if industry corrected. That would be a different emerging market. It's about equal anyway, even the way it is.

In the U.S., there is this complexity with a large cap that did very badly from '98 to 2008, and did normally after. So what happens in the U.S. is that if you would take an index, which is not including the largest market caps, so anything like the S&P 400, S&P 600, or some older indices, or you take a dimension of fund advisor returns, things like that, or the crisp with Chicago indices, you would find that private equity was very close to public equity over any time period.

The problem is when you use the S&P 500 to give you an idea over the last hundred years in the U.S., if you take any size categories and you calculate the 10 years returns, and you just roll it, right? You start in 1920, and you say, "Okay, 1920 to 1930, 1921 to 1931." You do this 10 years rolling for hundred years in the U.S., there's not a single category in this 10 size desize that have ever had a decade with negative returns, except for one category in one decade. And it is the largest gap of the top 10% from '98 to 2008. It's the only one. So an index like the S&P 500 has an extremely performance low from '98 to 2008. So up until 2008, whenever you would see an investment presentation, it would be benchmarked against the S&P 500, because it was trivial to be the S&P 500. So people keep on playing with that.

So when they show you the last 10 years of performance in private equity in the U.S., they will never show it to you against the S&P 500, because it's going to be close to one to one. When they bring in the S&P 500, it's going to be the past 20 or 40 years, because then it's going to include the '98 to 2008 time period.

If they're going to show you a recent period, they're going to use MSCI World because it's the worst performing index over the last 10 or 15 years, but if throughout, someone would've used a stable index like S&P 400 or something like that, you would've seen that any horizon, it would be very close to the public equity in the U.S. And like I said, in the U.S., the mix is pretty similar, so it is a reasonable comparison. So it's not bad returns. And if private equity has been a bit diversifying net of all fees, if you get about the same as public equity, it's actually hasn't been a bad deal. It's not the amazing deal that the consultants are selling to you, but it hasn't been a bad deal.

Now going forward, one has to think about whether a high fee in a low interest rate environment is a good idea, right? So if you're going to have expected returns, even if private equity outperforms public markets growth of fees, and they do, you have a very high fee structure. And so in a compressed return environment, how does that work? Right? So usually, it's not very good news. That's why I encourage people to think more from fundamentals about the future, rather than just looking at the track record saying, "It wasn't bad in the past, so it's cool." But it's still important to know that in the past, it's not as rosy as what consultants tell you.

So you mentioned earlier looking forward, expected returns. Is that all there is to it, that it's high fees in a low interest rate environment?

Yeah because the rest is highly speculative. It's hard to say that would be my number one. My number two, that would be in the order of what is less speculative. So less speculative would be high fee, lower expected return usually is not a good mix. And that's how to disprove. The second one is that historically, so slightly more speculative, but there is some research backing to that, historically, any asset class, any sub asset class that has... that if you want to try to see what is the best predictor of very expected returns is the flow of money that went to it. So whenever you have a country, for example, that becomes unfashioned, like things about the BRICS, for example. The Brazil, Russia, India, China, South Africa. In 2005, 2006, that was the place to go. Money was flowing in these countries like mud. Look at it today, 15 years later. How many of these countries offer the good return? Maybe China.

And that even is not clear because it is really so so. You have the ones who are in a catastrophe, right? An absolute catastrophic. So the flow of money in about any asset class is the best predictor of expected return, right? So that doesn't mean it would continue his relationship, but it's pretty strong. So venture capital, for example, in the U.S., the best vintages, so the best moment to invest in venture capital was 2004, five, six, seven. I can tell you, who was around back then, nobody wanted to touch venture capital in 2004, five, six, or seven. There was very low flow of money. Why? Because people had been burnt in the last 90s. So all the early 2000, nobody wanted to invest in venture capital and we saw very good vintage years. Now, everybody is investing in venture capital U.S. and wants to be there. So this may not be very good.

European venture capital, nobody wanted to touch it until very few years ago. And returns had been good for the vintages like 2010, 2014. The private equity in Africa in one point was very much on fashion like '08, '09 didn't end up well. So the places where you have like a lot of fashion, it's usually when there is problems. You need to remember this old American say, which is, "When the shoe shine boy is telling you which stock to buy, there is no better moment than to just sell everything and go away." Buy a house. Just sell all your stocks and go buy a house, buy a leg. A taxi driver would tell me that they want to invest in Blackstone or things like that. Right? So we need to be mindful of this saying.

I'm going to ask you for a speculative number and you don't have to give me one, but if you were to assign an expected return to private equity as an asset class, maybe just relative to public equities, would it be above or below?

I think it's going to be very close. Maybe it be below because of a higher fees, but I see it as very close.

Okay.

I really don't see how it is possible to outperform net of fees with this fee structure in a lower expected return environment. And they're paying high prices for assets, so, but you never know, because look, the COVID hit and they was supposed to die. If you are high level and you're hit by your shark, but then the government decide to rescue everyone. So, good. Now you have this massive inflation, all kinds of problems on property companies, but maybe inflation will wipe out their debt, and so maybe they will end up all right. I don't think it's the most likely scenario, but you never know. So I think the average scenario will tell me that it's going to be very tricky.

How successful has investing in private equity been for the institutional investors of the world?

If you look at pension funds in the U.S., for example, where you can get data, it's amazingly close. So the IR would be like 11%. So when it's at 11%, you can trust it. So like CalPERS, like 10.5. So, that's a reasonable number. And remember by U.S. stocks, you can check it. The average stock in the U.S. Again, not the S&P 500. That will depend on the horizon, but the average stock in the U.S. will be at about 10, 11% on any five to 10 years period. So, that squares up what I just described. And if you look at the multiple of money, CalPERS reports that they got $1.50 for every dollar invested. What is interesting is that not all pension funds report their IR and they didn't all start at the same time. You need some complexity there, but the multiple of money is a good number to compare across pension funds.

Nearly all of them have 1.45 as a multiple of money in private equity. And you take Washington, Oregon, which are the oldest investors in private equity in the U.S. You take newer ones, they're all at 1.5, 1.45. It's incredibly close. So it seems to be the thing. And 1.4, 1.5 is what you get if you invest in about for four years at 10% a year. That's exactly what you get. So we know what they've got is what I just said. They got about 10% a year. And so these pension funds as well, one mistake they make often, or willingly or not, the consultants certainly push it this way willingly is that then they say, "In private equity, we have 10, 11% return at about any horizon." Which is not bad and they're right, but in public equities, much less.

And there, the mistake is their public equity is globally diversified, not their private equity. So their private equity is mainly U.S. And so their private equity did as well as U.S. public equity investment by pension fund, but the rest of the market, the U.S. dollar has appreciated. So if you take MSCI World, it has very bad returns in U.S. dollars. And so pension funds in the public equity positions have roughly the MSCI World Index, and so then their returns are much less than private equity, but all you need to do is split. And sometimes they do report it. You take a pension fund and say... You look at American public equity versus non American public equity, and you will see that their product equity portfolio is very close in returns to their American public equity, but indeed much higher than the non U.S. public equity, but that's because of the U.S. dollar and idiosyncratic things. Nothing to do with private equity doing better. So when you observe a portfolio of pension funds and the returns, it's actually very coherent with all the numbers I gave.

You mentioned the huge firms like Blackstone and KKR. How does their performance compare to the average private equity fund?

Yeah. So I haven't done it for a long time. I always resisted to take a name, not to pick someone. And so I did it in this paper on the billionaire factory because people kept on saying, "Well, I don't believe you." But at least the top quartile do better. So at first, people say, "I don't believe you." Then I say, "Go on the website of CalPERS and do all the pension funds one by one, look at the numbers and you will see it's 10, 11% written there. It's not 30%, okay? It's 10, 11. That's what is written." And then people say, "Well, but they're top quartiles. Okay. CalPERS is stupid." I say, "Well, I disagree, but fine. Okay. They're top quartile." So who are these top quartiles? And they always come up with these names like, "Oh, KKR is at 30% return, Apple, 26. Apollo is at 40% return and also fees, etc."

So I say, "Okay, then let's take these names. Let's take that track record because it's in public filing so you will be able to check yourself. So it's not my own numbers, okay? Let's go on the SEC filings and let's look at the numbers." What's amazing is that these guys never give the multiple of money net of fees, which would be the only thing that is making some sense, right? They report on net of fees IR, but as we discussed, it's not very helpful. So the net fees of KKI is at 26. The net fees of Apollo is at 30. The net fees of Blackstone is at 19, etc. So, this is not particularly interesting. These are IRs, right? We know it is not quite right. And if you look at a multiple of money, you don't have a net of fees.

So it's not very helpful to know how much make gross of fees. We know it's a lot gross of fees, but it has to incredibly close to one another. So gross of fees, they are all close to two. And if you make twice the money in gross of fees, you can calculate how much normal fees are to see where you are net, and you end up at 1.5, which is exactly what all the pension funds are reporting. And most of the money of pension funds is invested with KKR, Blackstone and all these guys. So it's all, again, completely coherent. You go to the SEC filings of GPs. If you don't look at the big numbers, they flash you away, but you dig out the ones that are more difficult to put greater on, you'll find coherent numbers. Again, it's not bad for returns. The past returns are not bad, but it's not what marketers, "consultants" are advertising.

And the other one a lot of listeners will... are probably wondering about right now is, what about Yale?

Yeah. So Yale had reported an IR for many years. They had never said so and then I gave a very hard time about that. And then now, we put it all over their annual reports in full notes and the likes saying this is an IR so you need to treat it with caution, blah, blah, blah. Mia would just not put it in annual report. And I would ask them to still put a money multiple. I would like to know what is money multiple of Yale. They never reported it. Any investment professional, when you tell them IR is BS, they tell you, "Oh, yeah, but you have a money multiple next to it so then this is how you can have a better assessment of performance." Say, "Well what is the money multiple of Yale?" We don't know. Nobody has ever told us. Would be good to know.

I'm sure it's decent because they are very smart. They did the number of choices that are very smart, but we don't know their money multiple. And even less so, their PME. I don't know. I'm sure it's decent, but it's certainly not the 30% that is advertised because this is an IR. So we know it's not that. We don't know real number.

You may have answered this when you talked about the U.S. and non U.S. for comparing performance, but why do we hear that private equity has been the best performing asset class for institutions?

Yeah. So this is exactly the thing because they merged together all public equity and private equity, and you have a tilt that in private equity is mainly U.S. and in public equity is mainly... it's quite a bit. Half is non U.S. for the average institution in the U.S. And so with the dollar strengthening and emerging market not doing very well over the last 10, 20 years, you get that result. It's totally mechanical.

So do you believe that private equity offers diversification benefits to a public equity portfolio?

It's reasonable to think so. It's reasonable to think so. My question is to which extent. And then is when you need to do a bit more homework that some private equity funds one can see intuitively we offer diversification, but if you see some private equity firms investing in something like Hilton hotels, and you have a Marriott that is publicly listed in terms of divers diversification, I'm not sure, but it helps me to buy into Hilton on the private equity side when I can have Marriott on the public equity side. So it depends on the strategy. So usually overall, the larger a fund is, the more they invest in mainstream type of companies, and so the more similar they are to publicly traded once. So if you want to look for diversification, you would tend to go towards more niche fund and most of it construction, right? Somebody doing software in Europe, I guess, if there's no such things that are publicly listed. So yes, that would be fine. I don't know if it's a good return or not, but that would be diversified.

Ah, yeah. Okay. No, that's an interesting way to think about it. You mentioned Hilton, I got to ask about it. That seems like the best thing that private equity ever did for investors. Do you think that the LPs benefited from that deal?

So I updated the case and now it's on ssrn.com, we did very careful calculations, very detailed. It's the case study we use with students to show the importance of benchmarking property. On paper, it's the largest capital gain ever. It's 10 billion of capital gain plus actually, it's more than that. And it's interesting to see that if you try to reconstitute how much went to the LPs, it's close to what they would've got with Marriott. So they got zero. They actually underperform Marriott, even if you do reasonable fee estimates. And so this massive capital gain is all down to Marriott went up by as much. Blackstone to more than 2 billion in fees. The management took half a billion in compensation. The selling shareholders got tons of money. So lots of people receive money, but the LPs, it looks like it was a bit rough for them.

Yeah. That case study is fascinating because it's like I said, it's like that's what's the showcase for private equity like, 'Look what you could have participated in." Given what we talked about so far, why do you think sophisticated investors are allocating to private equity?

Because one should not use the name sophisticated so much. It's that the people are driven by all kinds of objectives when they're managing other people's money. So if I'm working for a pension fund and I'm a private equity specialist, I spend 25 years in private equity. Am I going to go to all pension fund and say, "You know that these numbers you hear in the press by consultants and stuff, they are not really real. Okay. It's not that good. And there are all these fees we don't know about and stuff like -" What are they going to do? They're going to shrink my division, maybe even fire me. They're going to stop investing in private equity. So if I know about private equity and all these things, I'm not going to make noise. Okay. I'm just going to say, "It's okay. It's under control. We're monitoring it. It's fine."

Right. And I'm going to go to a board and say, "Look at this consultant report. They say we should invest more in private equity. Why don't you add a few more people to my team and give me more money?" So it's because we're just naive, but it could be also willing that people say, "Oh, but it's sophisticated people playing with sophisticated people so it should all be good." In the first paper I wrote 20 years ago, people said it was showing... the details were not very good.

And people said it cannot be because these are willing adults signing contracts with one another, and people are still investing in these guys. So you can only be wrong, right? Because why would they invest, right? The world is a bit more complicated than that. There was all kinds of conflicts of interest, there is all kinds of all the objectives that people are following. And investing in private equity is a lot more exciting than investing in bonds. So if I do a show of hand by my students, nobody wants to do fixed income or ETFs or things like that. They want to do private equity. It's a lot more exciting. I don't blame them. I would do the same.

Is there a way that investors can approach private equity to expect to be successful?

Yeah. There are some exceptions. Oxford Endowment for example, is probably my favorite investor in private equity. I invite the deputy CIO of Oxford Endowment every year to my lecture to expand his approach to private equity. They invest a lot in it and I find him making complete sense, but he invests... It's not too far from David Swensen philosophy. He invests with very niche private equity funds. That's one thing. So David Swensen never invested in big names. He never invested into the Blackstone, KKR, etc., and neither does Oxford Endowment. So they invest in very niche people where they can see that there is a case for outperformance and the case is really spelled out, etc. They don't say, "Oh, you have a good track record. I'm giving you money." It's like, "Explain to me why going forward, you have identified the cake, but there is indeed the cake and nobody will come eat it instead of you. Explain that to me." Right. And I think this is very important.

People should spend much less time looking at track records and much more time doing what I just described, which is much more difficult, which is probably why they prefer to focus on track records instead. So they're in the same things that are very niche and they use their competitive advantage, which is that when you are Yale Endowment or Oxford Endowment, your name can help the GP quite a bit. And so they tend to be betting a strong position to write contracts with the GPS that are aligned interest much better. The GPS not going to lie, do things in their back of things like that, because this is a very important anchor investment. And they get to see a number of things. They get also to talk to people.

It sounds silly, but if you pick up a phone and say, "This is Oxford Endowment and I have a question about your ex employer. Can we talk about that?" People say, "Yeah, sure. Let's have a talk." If I call, say, "I'm Ludo. I'm trying to invest in this fund. I would like to..." You're not picking up a phone. Okay. It sounds silly, but it does happen. If David Swensen calls you to ask you a question when he was alive, he would pick up a phone, right? People would. And according to the people here at Oxford Endowment, you obtain incredible amounts of information by talking to people. So for example, an example that he gave in my class was you have a fund sending you a prospect. It still looks good. They were very interested. And the fund says that all of the ideas are propietary, right?

So classic thing, it's always one to one, they have this niche do very well. So yeah, they are very interested in that. That answers the sorts of questions I just gave earlier. And so they call the investment banker that was dealing with this acquisition and the one that was dealing with other acquisition, etc., and say, "How did it go with sell? What happened?" And he say, "Well, we had a good file. At the auction, we could do blah, blah, blah." And say, "Oh, there was an auction. Okay. Tell me about the auction." Right. And if you don't have access to these guys, then you don't know. He say, "Wow. So apparently, these guys pretend that it's all proprietary. So not only it's not the case, but on top of that, they lied to me." Right? So that's a no. So I do know some LPs that are... it's making sense when they explain why and how they invest in private equity. I just don't know that many of them, but there are some, yes.

So if an investor does not want to invest in private equity, can they replicate those returns in public equities?

I created an index that's mimicking it pretty closely, I think, and making lots of sense. It's currently not available to the broad public. I was talking to a firm to make it an ETF, but with the recent market turmoil, it was put on hold, but if anybody is interested, that's feasible. This index was developed by J.P. Morgan, but it's for large institutional investors if you're interested. But we found that you can put together a portfolio for about a hundred publicly listed companies in the world that are involved with private equity. And if you're quite smart at doing your liquidity management and you are waiting, you could get a portfolio that is very close to what Cameron just said returns are.

Interesting. And you said that index is available for large investors?

Yeah. So if you're J.P. Morgan client, you could see the index live on Bloomberg. If you're not, you cannot see it yet, but I'm updating the paper that has been posted on SSRN where I will even try to put them on my website in a few months, hopefully, the index live so that you can track private equity live. So the irony is that I started working on this index in 2020. And when it was ready, it was about May, 2020. And it was still under embargo at J.P. Morgan, because they wanted to try to sell it before it would be known what the methodology is roughly. And so they kept it embargo for 18 months. And during is 18 months, my index went up by more than 80%, but if you looked at private equity returns as well, they went through a roof, right?

If you take from the pandemic afterwards, they also went through the roof. So we saw some private equity guys announcing that even on nav to nav basis, the return were 50, 60, 70%, but so did my index. But over the last month or two, my index is down quite a bit, right? But again, it's making sense. Private equity is quite down. They have difficulties raising money, our people are very nervous about the expected returns. So it seems to be going in the right direction with the right magnitudes. And in the past, we can back test it to 2008. All the movement seems to be making sense and the average return matches exactly the Cambridge associates average return. My index has an average return of 13%.

That's super interesting. All right, Ludo, the last question we have for you, how do you define success in your life?

To be happy. People need to find something that makes them happy.

That's a great answer. I want to ask you, I had a bonus question just real quick, quick answer because we talk about the value premium a lot, is the value premium risk based or behavior based?

I lean towards behavior based because I don't see the story of value gives you more return because these are riskier companies. If I look at the list of companies that are value, and I look at the list of companies that are growth, I have a very hard time to define what kind of risk it is that these value companies have and the growth ones don't. If I give you list of growth companies like Tesla and all these things, I'm not sure if you're a lot safer investing in these that I would in Walmart. So I don't see how a value premium could be a compensation for risk. No.

Interesting. And you've got papers on this too we can link to this?

Yeah.

Awesome. Ludo, this has been fantastic. We really appreciate you coming on and your stuff on private equity is just... it's so good. It's fantastic.

Thank you. Thank you for having me.