Ep63 “What Explains the Growth of Private Equity? A Different Perspective” with Ludovic Phalippou

All Else Equal Podcast: Private Equity Markets - Summary

Key Concepts:

• Private Equity (PE) & Private Debt: Alternative investment vehicles focusing on non-publicly traded companies.
• Fundamental Theorem of Corporate Finance: Trade-off between risk diversification and monitoring capabilities in corporate ownership.
• Principal-Agent Problem: Conflicts of interest arising when one party (agent) acts on behalf of another (principal).
• Mega Asset Owners: Large institutional investors (e.g., pension funds, endowments) with significant capital.
• Benchmarking: Comparing the performance of an investment against a relevant market index or peer group.
• LBO (Leveraged Buyout): Acquisition of a company using a significant amount of borrowed money (debt).
• NAV (Net Asset Value): The value of an entity's assets less the value of its liabilities.
• Semi-Liquid Funds: Investment funds that offer limited liquidity compared to traditional mutual funds.
• Evergreen Funds: Funds that do not have a fixed term and can continuously raise and invest capital.
• Regulatory Arbitrage: Exploiting differences in regulations to gain an advantage.
• Carried Interest: A share of the profits of an investment fund paid to the investment manager.

I. Introduction: Private Equity and Private Debt Growth

• The podcast discusses the growth of private markets, specifically private equity and private debt, over the past few decades.
• The central question is: Why are private equity firms the appropriate entities to hold equity and provide debt to corporations?

II. The Fundamental Theorem of Corporate Finance and Private Equity's Role

• Jonathan Burke introduces the "fundamental theorem of corporate finance," highlighting the trade-off between concentrated ownership with high monitoring but high idiosyncratic risk, versus diversified ownership with low monitoring but lower individual risk.
• Private equity firms potentially solve this by providing active monitoring through board representation while allowing investors to diversify by investing in multiple PE firms.
• However, Burke points out that this may simply shift the principal-agent problem further down the chain, as PE firms and their investors also face monitoring limitations.
• Jules Van Binsbergen emphasizes the importance of monitoring and suggests that PE firms sell themselves as superior monitors, leading to better resource allocation.
• The discussion touches on the cyclical shifts between public and private markets, questioning whether the increasing importance of monitoring or prohibitive public market regulations drive the trend towards private equity.

III. Data Transparency, Performance Measurement, and Benchmarking Challenges

• Burke notes the difficulty in measuring performance in private markets due to self-reported data, contrasting the academic skepticism towards public market intermediaries (mutual funds) with the generally positive view of private market intermediaries, despite data limitations.
• Van Binsbergen highlights the challenge of establishing appropriate benchmarks for private equity firms, making performance evaluation difficult and potentially allowing for a "fudge factor."
• The conversation introduces Ludo Filippo, author of "Private Equity Laid Bare," known for his critical perspective on private equity performance measurement.

IV. The Economic Rationale for Private Markets: Ludo Filippo's Perspective

• Filippo argues that private markets are a natural habitat for capital, given that most investors (endowments, pensions) do not require the millisecond-level liquidity of public markets.
• He challenges the traditional view of diversification, suggesting that private markets can offer better diversification than public markets.
• Filippo posits that private markets align management incentives with shareholders through steep incentives and performance-based compensation.
• He suggests that mega asset owners can directly hold and manage companies, negating the need for public markets in many cases.

V. Challenging the Fundamental Trade-off: The Rise of Mega Asset Owners

• Filippo challenges the fundamental trade-off of corporate finance, arguing that mega asset owners can achieve both diversification and effective monitoring.
• He uses the example of Hugo Boss, now owned by a family office with a diversified portfolio, to illustrate that companies don't necessarily need to be held by thousands of shareholders.
• He extends this argument to private credit, suggesting that pension funds can directly make loans, bypassing banks and private credit funds.

VI. Principal-Agent Problems and the Convergence of Public and Private Markets

• Burke questions whether the shift to private equity simply moves the principal-agent problem to the relationship between investors and PE managers.
• Filippo agrees that principal-agent problems persist but have shifted. He envisions a convergence of public and private markets, with stock exchanges facilitating over-the-counter trading of private company shares.
• He emphasizes the significant principal-agent problems between Limited Partners (LPs) and General Partners (GPs) in the private equity setting.

VII. Multiple Layers of Agency and Monitoring Challenges

• Burke suggests that investors in PE firms spend more time monitoring managers, creating a more direct link between ownership and control.
• Filippo counters that multiple layers of agency exist, with end investors being several layers removed from the actual investment, making monitoring difficult.
• He points out the potential for conflicts of interest at each stage of the agency chain.

VIII. Secular Trends Driving the Growth of Private Markets

• Van Binsbergen asks about the major forces driving the long-term trends favoring private equity and private debt.
• Filippo notes the US-centric nature of private debt and the regulatory arbitrage opportunities for insurance companies and banks.
• He cites a paper by Julian Bigenot and Siri Vardani at Pravad, arguing that the core reason for the growth of private markets is the belief in higher returns.
• He criticizes the "anti-ecosystem" that benefits from complex private equity structures, including consultants and fund managers who justify high compensation through cooked statistics.
• Filippo emphasizes that private equity is the most expensive form of financial intermediation, with average LBO funds charging around 7% per year in fees.

IX. The Value Proposition of Private Markets and the Justification of High Fees

• Van Binsbergen questions whether the high fees are justified by the services delivered or if private markets should be largely replaced by public markets.
• Filippo believes there is a place for private markets, but the fees should be commensurate with the services. He notes that the high fees and issues are concentrated in large, US-based LBO groups.
• Burke argues that high fees are justified by the skill and monitoring capabilities of PE partners.
• Filippo counters that he would accept this argument if PE firms were transparent about all fees and expenses.

X. Fee Transparency and Conflicts of Interest

• Burke suggests that Stanford Endowment receives clear fee disclosures, which should be sufficient.
• Filippo argues that until the mid-2010s, many fees charged on the assets were not disclosed, even to endowments. He documented instances of PE firms charging portfolio companies for their own consulting services.
• He raises concerns about the transparency of fund expenses, such as private jet travel.
• Filippo highlights the conflict of interest where individuals controlling a company can appoint themselves as consultants and set their own fees.

XI. Endowment Performance and the Illusion of Superior Returns

• Burke points to the strong performance of university endowments, which invest heavily in private equity, as evidence of its value.
• Filippo acknowledges that the average private equity fund has historically delivered around 11-12% net of fees.
• However, he questions whether this performance will continue in a lower-return environment, given the high fees.
• He suggests that endowment returns are often inflated by comparing private equity portfolios with US tilts and tech tilts to public equity benchmarks with European stocks and exposure to underperforming sectors like banks and oil.

XII. The Endogenous Selection of Private vs. Public Firms

• Van Binsbergen raises the issue of endogenous selection, suggesting that firms where management fees are most valuable are more likely to be private.
• Filippo agrees that the belief in higher returns drives demand, but supply, regulatory, and market infrastructure factors also play a role.
• He envisions a future where private markets handle buy-and-hold strategies and turnaround situations.

XIII. The Importance of Benchmarking and the Gaming of Performance Metrics

• Van Binsbergen emphasizes the importance of benchmark selection in evaluating performance.
• Filippo argues that disagreements about private equity performance stem from benchmarking issues.
• He criticizes the use of the S&P 500 as a benchmark in the 2000s, as it underperformed small and mid-cap stocks.
• He points out the practice of excluding underperforming sectors (utilities, real estate, oil and gas) from private equity portfolios while including them in benchmarks.
• Filippo concludes that when comparing US private equity to appropriate US small and mid-cap benchmarks, the performance difference is minimal. He also notes that European private equity appears to outperform European stock markets, but this is due to the poor performance of European stocks, not superior private equity performance.
• He accuses the industry of "gaming and cooking" performance metrics.

XIV. Conclusion

• Burke and Van Binsbergen thank Filippo for his insightful comments.
• The podcast highlights the complexities of private equity markets, including the challenges of performance measurement, fee transparency, and benchmarking.
• Filippo's critical perspective challenges conventional wisdom and raises important questions about the value proposition of private equity.