Robin Powell (the evidenced based investor) makes a bold claim.
Ludovic Phalippou is a hero.
Who is Phalippou?
Ludovic Phalippou is an economist who has written a paper detailing the workings of the Private Equity industry and how it manages to pay itself $230bn from our money.
For those who want to see the data on which Phallipou’s conclusions are drawn, it can be downloaded, curated by Phalippou himself on linked in .
As promised, my last piece. I sign-off. I wrote all I know. All the calculations and data are on my website (which is not finished/updated yet: https://lnkd.in/dpUyws2). As I wrote in the intro, questioning returns in PE is akin to questioning the existence of god. It makes people very emotional.
Moving in mysterious ways…
Private Equity, like God, moves in mysterious ways. Here is the synopsis of Phalippou’s argument.
Private Equity (PE) funds have returned about the same as public equity indices since at least 2006. Large public pension funds have received a net Multiple of Money (MoM) that sits within a narrow 1.51 to 1.54 range. The big four PE firms have also delivered estimated net MoMs within a narrow 1.54 to 1.67 range. Three large datasets show average net MoMs across all PE funds at 1.55, 1.57 and 1.63. These net MoMs imply an 11% p.a. return, which matches relevant public equity indices; a result confirmed by PME calculations. Yet, the estimated total performance-related fee collected by these PE funds is estimated to be $230 billion, most of which goes to a relatively small number of individuals. The number of PE multibillionaires rose from 3 in 2005 to over 22 in 2020. Rebuttals from the big four and the main industry lobby body are provided and discussed.
Having read the 40 pages of the paper I agree with Phalippou’s fundamental message “PE is a surprisingly expensive form of financial inter-mediation”.
…. its wonders to perform
If , as Phalippou’s analysis suggests, PE is delivering what public equity delivers, only with a fee extraction of gargantuan proportions, we have to wonder who is paying the $230 bn bill. Anyone who has worked for an organisation that is funded by private equity knows what happens. Margins are squeezed, jobs cut and businesses run on the margin of effective delivery. Most UK care homes are owned by private equity, when COVID-19 came, most UK care homes did not have the capacity to cope. The wonders of PE have been cruelly exposed and we now know who paid the biggest price of all.
The examples in Phalippou’s analysis are various, he takes the leveraged Buy-Out of Hilton Hotels as a case study and analyses what actually happens. He looks at other cases in details and then deals with the various rebuttals to his analysis by the big four PE houses (Blackstone, Carlyle, KKR and Appollo).
What Phalippou points to in terms of finance, we experience in terms of value (or should I say negative value).
Have private markets anything to offer DC pensions?
At first sight- yes. There are those, the Pensions Minister among them, who have argued that there should be scope within the defaults of large DC schemes for “alternatives”, of which private equity plays a major part. The argument is that this is the way for these pension funds to invest into social enterprises (under the private financing initiative). Private Equity and Private Debt are seen as part of “patient capital”.
I support the investment of my pension fund into long-term liquid assets provided that it does not render my pension pot so illiquid that I can only access my money when my fund’s gate is open.
Several large DC pension schemes offer property funds without and within DC defaults that are currently “gated” to protect the fund. I have met trustees who are concerned that they may have a statutory obligation to “open the gate” if a member wants to transfer or take money at retirement.
Whether the risk is born by the trustee (and so to the sponsoring employer) or by the member, the risk of illiquidity is not born by the fund and asset manager who protect their performance numbers by not selling assets. This is the kind of chicanery identified by Phalippou, it is no more than a transfer of risk from the fund to its owners and so to the beneficial owners.
The social purpose of illiquid investment is clear, but where control of the capacity to liquidate is lost to trustee and member, the social purpose is of no use, you cannot eat social purpose.
Can large DC pensions access private equity?
The received wisdom is that the larger your pension scheme, the wider your investment options. For one thing, they can dilute the liquidity problems mentioned above by investing significantly without gating the fund as a whole.
In recent papers, Chris Sier has pointed out that larger DB funds (with more than a billion pound of assets) tend to swap public equity for private equity. Sier argues that private equity appears to provide less volatile but equivalent returns over time. Here his research and Phalippou’s seem closely aligned.
Recently I have been on several calls where large DC scheme trustees and platform managers are being pitched “alternatives” (mainly private equity) because that’s what £1bn pension schemes do. The IFoA are running such a seminar this week (details here- NB £35 joining fee for non-members).
It appears the privilege of a larger scheme that it can invest in alternatives. They are sold as producing the outcomes of a with-profits fund “equity type returns without the volatility”.
$230bn – A victimless crime?
Sier’s analysis suggests that this argument is accepted by the CIOs of large DB funds but it also suggests that the hidden costs of PE investment are high.
In private debt and private equity, for example, annual management charges only account for 33 per cent and 38 per cent of total costs
This appears to make private equity more “affordable” than it really is. The platforms that pay for asset management through private equity funds only need to pay a third of the real cost, the rest being passed on to savers through hidden charges that impact performance.
This slight of hand appears attractive if it enables members to get equity like returns without the volatility and trustees being able to show they are punching their weight.
But I am not buying the argument.
Firstly, while I can just about see why DB schemes are prepared to invest in PE to dampen volatility, I do not see the same need for DC schemes as they accumulate. DB schemes (ridiculously) have to account for solvency on a mark to market basis but DC members do not have a solvency issue, their only issue is to accumulate over time. They do not need to dampen down returns – which is why with-profits has not made a return into workplace pensions.
Secondly, there is a very real cap on charges on any DC fund that savers are defaulted into. While hiding 2/3 of the cost of running a fund in the unit price may look commercially attractive, it is not good governance, it is certainly not the kind of thing that trustees should be doing – not if they believe in transparency.
If the overall cost of PE is declared to members, what started as commercially possible -becomes difficult at all kinds of levels. And if the justification of investing in private equity is based on higher levels of ESG then trustees are going to have to deal first with the lack of transparency detailed in Phalippou’s paper
Second they are going to have to explain to those who are looking for responsible investment , how the plight of redundant work-forces and under-funded care homes equates with good societal values and good governance.
DC cannot afford illiquidity, has no budget for Private Equity fee structures and should not run the reputational risks highlighted by Ludovic Phalippou