Prof. Ludovic Phalippou: Private Equity, Under the Hood (EP.210)

Episode Summary

Executive Summary: The episode demystifies private equity with Oxford professor Ludovic Phalippou, focusing on what private equity actually includes, why performance is hard to measure, and why headline IRRs and ‘top quartile’ claims can be misleading. He argues that fees are much higher than commonly perceived, benchmarks are often wrong, and net outcomes for LPs are often closer to public equities than marketing suggests.

Main Topics: What counts as private equity (Priority: 5/5): Phalippou distinguishes between broad private equity, institutionalized private equity, and the narrower industry use of the term that often really means leveraged buyouts. He also notes confusion with private debt and private markets. How private equity funds are structured (Priority: 5/5): He explains the fund lifecycle: track record fundraising, commitments drawn over time, buy-to-sell investing, and the limited partnership structure that governs capital calls and exits. Why performance measurement is flawed (Priority: 5/5): The conversation centers on why private equity performance is difficult to assess: unrealized assets, lack of market prices, selective track records, and the distortions created by IRR and other shortcuts. Fees and hidden costs (Priority: 5/5): Phalippou estimates total annual fees for leveraged buyouts at roughly 6-7% and describes less obvious costs such as financing expenses, portfolio-company fees, and related-party transactions. How private equity compares with public markets (Priority: 5/5): He argues that once benchmarks are chosen correctly—especially accounting for geography and sector mix—private equity often looks closer to public equities than marketing materials imply, and in some cases roughly equivalent net of fees. Who benefits and why institutions allocate (Priority: 4/5): The discussion covers why pension funds, endowments, and consultants still allocate heavily to private equity: incentives, status, access, optimism, and the challenge of resisting a fashionable asset class. Can public markets replicate private equity? (Priority: 4/5): Phalippou describes constructing a public-equity-based replica index using listed firms connected to private equity, suggesting that much of the return pattern can be mimicked without owning private funds directly.

Key Arguments: Private equity is not one thing; most discussions really mean leveraged buyouts, not all private equity. Traditional IRR is often misleading because it assumes interim cash flows are reinvested at the IRR itself, producing nonsensical numbers when returns are high or negative. Unrealized holdings and manager-marked valuations make track records hard to verify; investors are often shown selective or stylized performance histories. Reported 2-and-20 economics understate total LP costs because of fund-level financing, portfolio-company fees, and related-party transactions. Performance comparisons depend heavily on the benchmark: sector mix, geography, size, and leverage all materially change the conclusion. In the US, private equity has often been close to public equity performance net of fees rather than dramatically superior, especially when compared with small- and mid-cap public benchmarks. Institutional investors often continue allocating because of incentives, consultant narratives, fashion, and internal career dynamics, not necessarily because of proven superior net returns. Expected future returns may be lower than historical ones because valuations are high and fee drag remains large. A niche, highly selective approach to manager selection—rather than relying on past track records alone—appears more defensible for successful allocators. A public-market replication approach can capture much of private equity’s return profile, implying the asset class may be less uniquely inaccessible than often claimed.

Data Points: Ludo's research focus: 15-16 years - He has specialized in private equity research for roughly 15 or 16 years. Estimated total annual fees for leveraged buyouts: 6-7% per year - Phalippou estimates LP all-in costs for US leveraged buyouts at about six to seven percent annually. Estimated fees for venture capital: ~5% per year - He states venture capital fees are lower than leveraged buyouts, around five percent. Estimated fees for real estate/infrastructure: ~4% per year - He cites rough fee estimates for real estate and infrastructure funds. Estimated fees for private debt: ~3.5% per year - He gives private debt as another lower-fee private market segment. IRR rule of thumb: 2-3% to 12% is meaningful; above that is often not meaningful - He says IRRs outside this range are frequently distorted or nonsensical. KKR reported performance: 26% annualized since 1976 - He criticizes the way KKR presents long-run annualized performance due to the IRR methodology. Apollo reported performance: 30% IRR / annualized-style figure - Cited as another example of a very high reported IRR that is hard to interpret economically. Blackstone reported performance: 19% IRR / annualized-style figure - Used as a comparison point among large public private-equity firms. CalPERS private equity return: ~10.5% IRR - He says pension-fund reported IRRs around this level are more plausible. CalPERS money multiple: $1.5 returned per $1 invested - Used to show consistency with roughly 10% annual returns. Typical gross money multiple for big GP firms: ~2.0x - He says large firms’ gross multiples are very close to one another. Hilton case capital gain: $10 billion capital gain on paper - The Blackstone-Hilton deal is presented as a showcase example, but LPs did not capture the headline gain. Blackstone debt in Hilton deal: $20 billion - Blackstone borrowed roughly the amount the market had valued Hilton at before the takeover. Beta estimate for buyouts: 1.3 to 1.5 - Some studies infer buyout cash-flow patterns are consistent with moderately elevated market beta, not extreme leverage equivalence. US buyout sector mix: One-third of deal volume in software - He emphasizes how much modern buyout activity is tech-oriented. Best vintage period for US VC: 2004-2007 - He says the best venture capital vintages came when fundraising interest was weak. Average return of his public-market replication index: 13% - He says his listed-company replication index matches Cambridge Associates-style averages and has a 13% average return. Index movement during embargo: +80% - He says the replication index rose more than 80% while under embargo during 2020-2021. Yale-style headline private equity IRR: Not specified precisely; discussed as an IRR, not a money multiple - He says Yale has historically emphasized IRR, but the money multiple is not disclosed.

Pivotal Quotes: "There is no easy answer to the question of how has private equity done." — Benjamin Felix: Introductory framing of why the episode focuses on measurement nuance and benchmark choice. "The IR is non-meaningful." — Ludovic Phalippou: His blunt summary of why internal rate of return becomes misleading, especially for high or negative values. "I think it's going to be very close, maybe a bit below because of higher fees." — Ludovic Phalippou: His forecast for private equity expected returns relative to public equities.

Implications: Listeners should be skeptical of private-equity marketing, especially IRR-based claims and vague ‘top quartile’ stories. Benchmark choice, fees, and selection incentives matter enormously, and future returns may be closer to public markets than many expect.