Episode 409: Investment Banker - What Private Equity Doesn't Tell You

Episode Summary

Executive Summary: Benjamin Felix and Dan Bordolotti speak with Jeff Hook about private equity, private credit, and other private markets, focusing on why institutions and retail investors buy them, why measured returns are often overstated, and why fees, illiquidity, survivorship bias, and subjective valuations make performance hard to assess. Hook argues these assets usually underperform simple public-market index portfolios net of fees.

Main Topics: Why institutions and retail investors buy alternatives (Priority: 5/5): Hook says institutions use alternatives partly for career preservation, ego, and complexity signaling, while retail investors are drawn by hype and the appeal of being in something exotic. Performance measurement problems (Priority: 5/5): The conversation centers on why private-market returns are difficult to evaluate: IRR can be misleading, valuations are self-reported, many funds are unreported, and benchmarks are hard to match. Private equity performance versus public markets (Priority: 5/5): Hook argues private equity once looked strong but has generally flattened and now tends to underperform public market equivalents net of fees, especially over the last 10 years. Private credit as the next promoted product (Priority: 5/5): The guests discuss private credit’s rapid growth, its similarity to leveraged loans/junk bonds, and Hook’s research finding no meaningful outperformance versus public floating-rate junk bond ETFs. Role of consultants, gatekeepers, and marketing (Priority: 4/5): Hook criticizes investment consultants and the private-funds ecosystem for providing cover, amplifying hype, and helping institutions justify allocations without rigorous independent verification. Liquidity, risk, and retail access (Priority: 4/5): A major concern is that retail investors may not understand lockups, gating, and embedded leverage; Hook warns retail access could reduce retirement outcomes even if the damage is not immediately obvious.

Key Arguments: Institutional allocators often choose alternatives not because they clearly outperform, but because the allocations help staff and consultants justify their existence and avoid blame. Retail investors are vulnerable to marketing hype and the desire for something 'sexy,' making them more likely to buy illiquid products with poor fee-adjusted odds. Private equity’s early outperformance was real in the first two decades, but competition for deals increased prices and compressed returns, leaving recent performance much weaker. Net-of-fee comparisons are what matter; gross-of-fee performance can look strong while investors still end up behind a simple indexed 60/40 portfolio. Reported returns are often inflated by unrealized marks, stale valuations, and survivorship bias; failing funds disappear from databases, leaving a rosier picture. Investment consultants and gatekeepers create air cover for institutions by endorsing large, brand-name funds, even when persistence is weak and future fund performance is essentially random. Private credit is largely private-equity leverage by another name: floating-rate junk-style lending to leveraged companies, with high fees and limited evidence of excess returns. Illiquidity is a real investor risk: private funds can be gated or locked for 10-12 years, making them unsuitable for money that may be needed on short notice. Allowing retail access to private markets is likely to lower retirement outcomes because fees are materially higher than public index investing and the advantages are hard to verify. The main reason private assets remain popular is not superior economics, but a mix of hype, social signaling, opaque reporting, and weak regulatory scrutiny.

Data Points: CalPERS-like public pension performance gap: 8.3% vs. 9.5% - Hook cites California's pension plan underperforming a Vanguard 60/40 index fund over 10 years. 10-year performance drag: 1.2% per year - Difference between CalPERS-style alternatives portfolio and a simple 60/40 index portfolio. Compounded gap over 10 years: 15% more money - Estimated wealth advantage from using the index fund versus the alternatives-heavy portfolio. State pension underperformance sample: 90% - Hook says 90% of state funds underperformed a simple index in a national review. Private equity relative return over last 10 years: Underperformed by about 1% to 1.5% annually - Hook references industry data from Bain, McKinsey, and State Street. Top-quartile private equity outperformance: About 2% to 4% annually net of fees - Hook describes the best private equity funds as strong, but highly selective. Bottom quartile private equity: About 75 cents on the dollar - He characterizes the bottom quartile as a major drag on aggregate results. Private credit study sample size: 200 funds - Hook and a UC Irvine colleague studied North American private credit funds. Private credit benchmark result: No evidence of outperformance - Their study found private credit roughly matched public floating-rate junk bond ETFs. Private fund reporting coverage: About 60% - Hook says a major private equity database covers only about 60% of the universe. Non-reporting share: About 40% - The remaining funds do not voluntarily report to the database. Private equity fee level: 2% to 3% annually - Estimated annualized all-in cost for institutional private equity funds. ETF fee level: Around 0.10% - Benchmark for a low-cost public index ETF. Fee multiple: About 25x - Private funds are roughly 25 times more expensive than a cheap ETF. Private credit fee level: About 1% to 1.25% fixed plus performance fee - Hook describes private credit fees as high despite lower complexity than private equity. Performance fee hurdle in private equity: 7% to 8% - Typical preferred return hurdle cited for private fund carried interest structures. Private credit growth: Tripled or quadrupled since 2015 - Hook says the asset class expanded rapidly as private equity slowed. Unsold assets in older private equity funds: 30% to 60% - Hook says mature funds still often have a large share of holdings not yet sold. Unrealized value overstatement: About 20% - He cites work suggesting unsold private equity assets were marked too high by this amount.

Pivotal Quotes: "the complicated portfolios don't beat a simple index, 60-40 index" — Jeff Hook: His core claim about institutional alternatives versus public index investing. "private credit is essentially privately held junk bonds" — Jeff Hook: He explains what private credit really is economically, rather than the marketing framing. "It's a great business for them. It's one of the best businesses ever designed." — Jeff Hook: He describes the industry’s incentives, opacity, and ability to keep raising capital.

Implications: Listeners should be skeptical of private-market marketing, especially net-return claims. For most investors, low-cost public index funds likely remain the better default; alternatives add complexity, illiquidity, and fee drag with little proven benefit.