Self Help

The Myth of Private Equity An Inside Look at Wall Streett’s Transformative Investments - Jeffrey Hooke

Author Photo

Matheus Puppe

· 32 min read



Here is a summary of the key points from the excerpt:

  • The excerpt describes a typical morning at the headquarters of the Maryland State Pension Fund in Baltimore.

  • The fund is overseen by veteran politicians Nancy Kopp (state treasurer) and Peter Franchot (state comptroller), who have little formal finance training.

  • The health of the pension fund has deteriorated over the past two decades under Kopp’s leadership, with a growing deficit that threatens retirees’ pensions.

  • Critics argue Kopp and Franchot are not engaged in improving the fund’s management, and instead make decisions based on political calculations rather than a rigorous study of best practices.

  • Many Maryland politicians seem indifferent to reforming the pension fund, believing it is an obscure topic to voters compared to more visible political activities.

  • The excerpt paints a picture of leadership lacking expertise and incentive to truly understand and optimize the pension fund’s investment strategy. There are implicit concerns about the political motivations overriding prudent management of retirees’ money.

  • The Maryland state pension fund has had poor investment performance for years, consistently underperforming compared to peer state funds and simple benchmark funds like Vanguard.

  • In 2008, the global financial crisis caused the pension fund’s assets to drop 20% and its unfunded liability ballooned to $15 billion. In response, the fund invested heavily in alternative investments like private equity and hedge funds, hoping for higher returns.

  • This strategy aligned with other state funds copying Yale’s endowment fund managed by David Swensen. However, Maryland’s returns remained below average while its fees quintupled to $500 million, directing money away from retirees.

  • The pension fund is overseen by a board of trustees representing various interests like state employees, the governor, legislature and executive branch. But the board is dominated by the staff, especially the chief investment officer.

  • Board meetings tend to be perfunctory, with minimal oversight or questioning of the fund’s investment strategy and poor performance. There is little accountability for continued underperformance.

  • In summary, the Maryland pension fund has shown poor investment returns for years but continues the same strategy with minimal oversight, accountability or change, while paying exorbitant fees to Wall Street managers rather than state retirees.

  • The Gibson Greetings IPO in 1983 was a pivotal moment for private equity, showcasing the huge profits that could be made with little personal investment by using debt-financed buyouts. This set off a wave of imitators and loosened lending standards.

  • The buyout frenzy culminated in 1988 with KKR’s $25 billion leveraged buyout of RJR Nabisco, which used $22 billion in debt financing.

  • The RJR deal highlighted PE excesses like management trying to steal the company via a lowball bid and KKR putting up little of its own money but making enormous profits.

  • The 1980s buyout boom marked a shift toward financial engineering and away from long-term management. It led to massive debt burdens and bankruptcies for some companies.

  • However, the trend was interrupted by prosecutions of egregious behavior, tighter lending restrictions, and the early 1990s recession. PE faded from prominence for a while.

  • The industry reemerged in the 2000s with new sources of funding like public pensions and grew to new heights, now managing trillions in assets globally. Though some practices are better, core model of high leverage and quick returns remains intact.

  • The 1980s was a time of greed and troubling business practices, as portrayed in the movie Wall Street. Financiers like the protagonist Gordon Gekko made fortunes by acquiring companies, selling their assets, and firing employees.

  • This “buyout boom” was driven by conditions that promoted such techniques.

  • Private equity (PE) refers to investment funds that buy mature private companies or take public companies private. The PE industry is comprised of three main sectors: leveraged buyouts, growth capital, and venture capital.

  • Leveraged buyouts (LBOs) represent about 65% of PE. In an LBO, a PE fund acquires all the stock of a company, finances most of it with debt, and appoints managers to run the business. LBOs target companies with stable earnings to pay back debt.

  • PE managers claim LBOs provide higher returns and lower risk than the stock market, contradicting financial theory. This claim attracts major investors.

  • Growth capital funds invest minority stakes in more mature companies needing to expand. Venture capital funds invest in younger companies.

  • LBOs are the main focus of the PE industry and this book. The high use of debt is claimed to boost returns of LBOs versus public companies.

  • Leveraged buyout (LBO) funds pool capital from institutions and wealthy individuals to acquire companies using significant debt financing. They were considered risky investments for fiduciary institutions like pension funds.

  • However, greater acceptance of modern portfolio theory (MPT) made LBO funds more appealing. MPT divides portfolios into “core” traditional assets like stocks and bonds, and “satellite” alternative assets like private equity. The purpose is to maximize returns while managing risk.

  • Institutions started viewing LBO funds as potential “satellite” holdings that could outperform the core portfolio while having low correlation to it. This made them more open to investing despite the risks.

  • Loosening of regulations like the “prudent man” rule also enabled institutions to invest more freely in alternative assets like LBO funds. The rules previously emphasized safety and prohibited riskier investments.

  • Tax incentives, bankruptcy law changes, and declining interest rates through the 1980s further fueled the rise of LBO funds. Institutions saw them as a way to earn higher returns than traditional investments.

  • The success of early LBO deals showed high returns were possible, making the funds more appealing. Favorable macroeconomic conditions also supported the LBO model during this period.

Here are the key points:

  • Pension fund regulations were laxed in the 1980s and 1990s, allowing them to invest more in equities and alternative assets like private equity. This provided more capital for leveraged buyouts (LBOs).

  • Junk bonds, pioneered by Michael Milken, provided a new source of financing for LBOs. Regulations changed to allow more conservative institutions like pensions to invest in junk bonds.

  • Favorable tax treatment made LBOs attractive - interest expense was deductible, most of the purchase price was depreciable, and capital gains taxes were low. LBO companies often paid little or no income tax.

  • The legal concept of “corporate veil” allowed LBO firms to treat portfolio companies as independent, shielding them from each other’s liabilities.

  • LBO activity surged in the 1980s with the RJR deal, slowed in the early 1990s, then rebounded in the mid-late 1990s as over 100 new LBO funds opened yearly.

  • LBOs evolved into three categories: classic (max debt), breakup (sell parts to pay debt), and strategic (expand via add-on acquisitions).

  • LBO funds now segmented into large ($500M+ deals), middle ($100-500M) and small (under $100M) markets based on skills needed.

  • The LBO industry now occupies a solid position in the US, with over 700 funds controlling 7,000 companies and employing millions. But it has also drawn criticism for ruthlessness and contributing to bankruptcies.

  • Private equity firms like Alden Global Capital have acquired newspapers like the Denver Post and imposed severe cost cuts, including laying off reporters and other staff. This has led to accusations that they are bleeding the papers dry to extract profits.

  • However, the PE industry argues it makes companies more efficient, creates jobs, and provides good returns for pension funds and other investors. Some academics previously backed these claims.

  • In reality, there is a large disparity between the wealth accrued by PE fund managers through fees and the more moderate returns for their investors. This highlights issues with the industry’s claims.

  • PE buyouts can benefit sellers of midsize, low-tech firms who now get fair offers to sell. Cash-strapped states also use PE to hit pension return targets and lower current contributions.

  • But the high fees and uneven performance have led to growing criticism of the PE model, with more pushback against the industry’s assertions. The lack of transparency makes data limited, but evidence against PE’s claims is mounting.

Here is a summary of the key points about how the private equity industry works:

  • Private equity firms raise funds from institutional investors like pensions and endowments. These funds have a fixed lifetime, usually 10 years.

  • The PE firms use this money to acquire companies, improve them operationally, and then sell them for a profit. This is known as the leveraged buyout (LBO) model.

  • PE firms make money through management fees, typically 2% of assets per year, and through carried interest, which is around 20% of the profits.

  • PE firms compete intensely to find attractive companies to buy. Deal sourcing relies on personal contacts and relationships with bankers, business brokers, etc.

  • PE professionals work long hours to find deals, analyze companies, negotiate transactions, and manage portfolio companies. Advancement to partner level is competitive.

  • While the returns can be high, the PE business involves major risks and uncertainties around identifying good deals, timing exits, and macroeconomic factors.

In summary, the PE industry is driven by raising funds, competing for deals, operational improvements, and well-timed exits to generate returns for limited partners. But it involves grueling work schedules and career advancement is difficult.

Here are the key points:

  • LBO funds raise money from investors called limited partners through blind pools, where the investments are not specified upfront.

  • Investors choose which LBO funds to invest in based on:

  1. Historical track record - Investors look at past performance of the fund managers’ previous funds, aiming to invest only in top quartile funds. However, studies show past performance is a poor predictor of future success.

  2. Borrowing track record via spinouts - New fund managers borrow the track record of their previous employer to raise funds, even though it’s not their own record.

  3. Brand name recognition - Institutions invest in big brand name funds like Blackstone for career protection. Even poorly performing brand name funds can still raise billions based on reputation.

  • Overall, the fund selection process is flawed, with past performance not indicative of future returns. Institutions favor brand names for safety rather than returns.

  • Fund managers contribute 3% of the fund size as their own investment.

  • After raising a new fund, private equity managers must find acquisition targets that fit the fund’s criteria. This deal flow comes from new business calls, referrals, and investment banks representing sellers.

  • Managers make many new business calls and attend conferences to generate leads. Referrals come from lawyers, bankers, consultants, etc. Sellers often hire investment banks, which contact many potential buyers.

  • A manager may look at 100 deals to close 1. Most leads go nowhere, but 15-20% get more follow up. After study, 1-2% result in offers, and 2-3 deals close per year.

  • Managers want to pay reasonable prices to invest the fund’s capital over 3-4 years. Goal is to operate multiple funds, building scale and exiting investments profitably to raise successor funds.

Here is a summary of the key points from the excerpt:

  • LBO fund managers face pressure from investors to invest the capital they have raised. This can lead managers to compromise on deal selection and pay higher prices as the fund life progresses.

  • Valuing LBO targets relies heavily on comparable companies analysis, looking at valuation multiples like EV/EBITDA paid for similar companies.

  • LBO targets are typically profitable companies with a history of positive EBITDA, not underperforming companies. Funds have limited capital to significantly re-engineer or improve the businesses.

  • Finding and analyzing LBO deals is a laborious, selective process similar to a mutual fund manager picking individual stocks. But LBO funds make far fewer investments (10-12 vs. 50+ stocks).

  • LBO funds claim higher returns versus public equities to justify fees and lock-up periods. But returns data does not clearly support this assertion, pointing to a more random outcome.

  • The private equity (PE) industry claims it has generated outstanding returns for investors, especially in the 1980s and 1990s. However, several independent studies since the early 2000s show PE funds have underperformed public markets over the last 10-15 years.

  • The industry’s claims of hyper performance rely on a narrow 10-12 year period in the 1990s, which is now over 15 years ago. Adding a liquidity premium for the PE investor’s inability to sell, the industry’s justification is questionable.

  • About 56% of PE deals since 2006 have not been sold, meaning returns are largely based on managers’ estimates of what they could sell deals for, not actual cash returns.

  • PE performance data captures only about 60% of funds, leaving 40% unreported. It’s unclear if nonreporting funds do better or worse than average.

  • PE fees are much higher than public index funds, meaning more investor money goes to fees versus investments in PE.

  • The business media has largely avoided reporting on PE underperformance over the last two decades due to the complexity involved.

In summary, the PE industry’s claims of outstanding historical performance rely on a short time period in the 1990s. More recent independent studies indicate PE has underperformed public markets over the past 10-15 years.

  • There are concerns about the accuracy and reliability of private equity performance data reported by industry databases like Preqin. Issues include potential survivorship bias, lack of third party verification, and possible manipulation of returns through financial engineering techniques.

  • The prolific use of credit lines by PE funds to buy companies ahead of capital calls from investors can artificially boost IRRs by shortening the holding period. This helps funds exceed hurdle rates for profit sharing and gain advantage in performance rankings.

  • Up to 77% of funds can claim top-quartile performance by selectively choosing data sources and manipulating start dates. There is a lack of standardization in performance measurement.

  • Common PE performance metrics like IRR, KS-PME, and TVPI have limitations. IRRs can be manipulated by timing asset sales. KS-PME relies on public market equivalents that may not be suitable.

  • Several studies suggest average PE returns are only modestly higher than public markets over the long term after fees, with significant variability across funds. Outperformance is concentrated in top quartile funds.

  • Overall, PE return data should be viewed with caution given potential biases, limitations of metrics, and lack of transparency around reporting methodologies. Claims of persistently high returns may be overstated.

  • There are three main metrics used to evaluate private equity fund performance: internal rate of return (IRR), public market equivalent (PME), and total value to paid-in (TVPI).

  • IRR has limitations, such as not accounting for the timing of cash flows. It can also be manipulated through tactics like credit line usage and vintage year shifting.

  • PME compares PE returns to public stock market indices like the S&P 500. The Kaplan-Schoar PME (KS-PME) is a popular metric but also has flaws like ignoring cash flow timing.

  • TVPI ratio of total value to paid-in capital is easy to understand but doesn’t account for timing. A ratio above 1.0 indicates a profit.

  • PE firms claim four tactics help them beat public markets: high leverage, improving operations, attaining critical mass, and buying right. But high prices and fees have constrained returns.

  • Leverage amplifies returns but also risk. 20% of LBOs go bankrupt according to some research. Financial engineering like dividends can boost returns.

  • In general, PE returns have not dramatically exceeded public market equivalents over the long term despite the claimed advantages. Returns are likely lower than what the industry reports.

Here are the key points:

  • Buyout fund returns are difficult to measure accurately due to reliance on managers’ subjective valuations of unsold portfolio companies. Performance metrics like IRR can be manipulated.

  • Standardized, transparent reporting would likely show annualized returns 2-3% lower and total value returns 10-15% lower than industry-reported figures.

  • Four tactics used to try to beat the stock market are: high leverage, operational improvements, attaining critical mass through acquisitions, and buying at opportune times when prices are low.

  • Success of these tactics is not guaranteed. Buying at the bottom of the cycle may be most impactful.

  • About 40% of deals produce no return, 40% modest returns, and 20% account for most gains. Outperforming the market consistently is difficult due to randomness of big winners.

  • While investors’ returns are mixed, fund managers tend to do very well from fees and carry regardless of absolute performance.

  • For decades, investors have searched for a “holy grail” asset that provides high returns with low risk, avoiding the volatility of the stock market. Private equity (PE) buyout funds have claimed to offer this.

  • PE funds claim they have lower risk (less volatility) and higher returns than public stocks. This seems implausible given the high leverage used in buyouts.

  • The author is skeptical of the PE industry’s self-reported annual returns data that shows buyouts having smoother returns than stocks. This likely indicates return smoothing by PE firms.

  • The author and others have created public stock indexes mimicking the attributes of PE-owned firms. During market crashes like 2008, these indexes showed losses similar to or worse than broad stock indexes, unlike the much smaller losses claimed by PE funds.

  • The high leverage used in buyouts should cause them to experience larger losses than unlevered public firms in market downturns. But PE claims the opposite.

  • The evidence suggests PE funds smooth returns to hide volatility and support marketing claims of “low risk, high return.” But this makes the “holy grail” of PE a mirage. The data is dubious but rarely questioned.

  • There is a historical pattern of private equity funds reporting smoothed returns that understate losses compared to public markets during downturns. This is attributed to optimistic portfolio valuations.

  • The author filed a whistleblower complaint with the SEC in 2013 alleging this practice by PE funds amounts to misleading return data in violation of securities laws. The SEC did not pursue action at the time.

  • A 2020 study provides further evidence of inflated early valuations, with PE returns declining as funds age.

  • Mark-to-market accounting involves judgment and comparables. This provides room for negotiation between funds and auditors that has facilitated return smoothing.

  • The accounting rule is to mark portfolios at fair value even during market crashes, but the industry exploits wiggle room. Defenses like “overcorrection” and being “long-term investors” are offered.

  • The PE industry reported muted losses in the 2020 crash compared to public markets. This strains credulity given the higher leverage.

  • Accounting rules provide PE funds an exemption allowing use of portfolio net asset value rather than fair value. This enables avoidance of markdowns.

The overall pattern is one of PE funds exploiting flexibility and discretion in accounting rules to smooth returns and understate losses compared to public markets, raising questions about accuracy.

Here are the key points about the annual fixed fee and performance fee of buyout funds:

  • Annual fixed fee is typically 2% of committed capital for the first 5 years of a fund’s life. This generates large fees for managers even when little capital has been invested.

  • Over a 10-year, $1 billion fund, fixed fees alone represent $145 million paid by investors to managers. In contrast, an index fund would charge only $1 million in fees.

  • Performance fee is typically 20% of profits above an 8% internal rate of return (IRR). This rewards managers even when stock market gains account for much of the returns.

  • Part of the performance fee may be held in a suspension account until the end of the fund’s life to account for uncertain outcomes. Excess fees are returned to investors.

  • In total, buyout fund fees are extremely high compared to index funds. The high fees make it difficult for buyout funds to outperform the stock market.

  • April 1, 1985 was an important date for the private equity (PE) industry, as David Swensen started as Yale’s chief investment officer. His mission was to modernize Yale’s investment approach by considering new asset categories like PE, hedge funds, etc.

  • Within 10 years, Yale moved away from traditional publicly traded stocks and bonds into alternative assets like PE, promised higher returns. This “Yale model” strategy was very successful.

  • Swensen became legendary in endowment management. Over the next 2 decades, many other institutional investors copied the Yale model and shifted into alternative assets like PE.

  • This rapid adoption of alternatives like PE by pension funds, universities, foundations etc. created massive fee income for Wall Street. It also required more staff and higher compensation at the investing institutions.

  • The Yale model and Swensen’s influence unintentionally led many institutions into alternative assets like PE, despite questionable returns for many. PE and other alternatives became a huge money maker for Wall Street.

  • Many institutions adopted the Yale model of investing heavily in alternative assets like private equity and hedge funds. This was driven by Yale’s past success, though results at other institutions were mixed.

  • Wall Street embraced the model as it resulted in vastly higher fees, despite studies showing minimal diversification benefits and better returns from simply indexing more to public securities.

  • Institutional investors include pension funds, sovereign wealth funds, university endowments, foundations, and fund of funds. They have over $100 million in assets under management.

  • Key objectives are preserving capital, avoiding large losses, and achieving a reasonable return of around 8-10% annually.

  • Institutions previously viewed alternative investments as niche assets to boost returns. The Yale model prompted them to dramatically increase allocations to alternatives like private equity, seeing it as a way to beat public market returns with less risk.

  • Alternative investments like private equity, hedge funds, and private real estate were expected to provide higher returns than traditional public investments, with lower volatility. This was based on historical data showing alternatives lost less than public markets in down years.

  • Institutions doubled their allocations to alternatives, increasing fees to investment managers, in hopes of achieving these higher returns. But the performance has often not matched expectations.

  • Institutional executives promote complex alternative investments to justify their roles and fees, using opaque metrics and reports that even board members have trouble understanding.

  • As fiduciaries, institutions must act in beneficiaries’ best interests when investing, but often rely heavily on potentially biased consultants from the finance industry in making decisions.

  • Board members, lacking investing expertise, rubber-stamp alternatives without proper due diligence into high fees and expenses. Proper standard of care in selecting and monitoring investments is often lacking.

  • Issues like vanity, self-importance, and cozy relationships between institutions, consultants, and investment managers may improperly influence decision-making away from beneficiaries’ best interests.

  • Pension plans spend huge sums on private equity buyout funds with minimal due diligence compared to what companies do before a merger/acquisition. They rely too heavily on self-reported numbers from fund managers instead of verifying independently.

  • Lack of proper due diligence is explained by: a) belief pension plans can pick winning funds, b) executives want to justify their jobs by having complex portfolios, c) consultants push alternatives though contradictory to theory, d) executives get too cozy with Wall Street and lose objectivity (“Stockholm syndrome”).

  • David Rubenstein exemplifies buyout success, amassing billions through Carlyle Group funds. However cracks emerged as funds underperformed, bankruptcies happened after excessive debt leverage, and dividends were extracted before failures.

  • Buyout funds have small staffs of investment professionals who source deals, monitor portfolio companies, and manage client relations. General partners get 20% of profits, while limited partners provide nearly all the capital but have little say in decisions. Staff compensation is lucrative from bonuses and carry participation.

  • Megafund complexes like Carlyle have three main components: investment professionals, administrative employees, and operations advisors.

  • Investment professionals make up the largest group and look for deals, analyze targets, negotiate transactions, raise financing, monitor portfolio companies, etc. They typically have investment banking or consulting backgrounds.

  • The group is dominated by white males, with women making up less than 10% of partners at top funds.

  • Deals involve teams with different levels of experience to promote execution and continuity. Cash compensation can range from $150k for a first year associate to $1-2 million for a managing director/partner.

  • Fund professionals have a fiduciary duty to maximize fees and carried interest for the fund, which can sometimes conflict with duties to portfolio companies and investors.

  • State legislatures have the power to oversee public pension plans, but often fail to exercise adequate oversight due to lack of financial expertise, inertia, and lobbying influence from private equity firms.

  • Public sector union leaders represent the beneficiaries of public pension plans, but have been strangely silent about poor investment performance and high fees charged by private equity funds. This may be due to a belief that shortfalls will be covered by increased government contributions.

  • Accounting authorities like FASB and GASB establish accounting principles for institutional investors. However, these principles enable pension plans to overstate private equity returns through manipulative valuation techniques.

  • The IRS has complex regulations governing nonprofit organizations like university endowments. But enforcement is limited, allowing endowments to over-allocate to high-fee alternative investments.

  • The SEC requires detailed disclosures from public companies but lacks authority over private equity funds. Recent whistleblower cases exposed misleading performance claims at some top funds.

  • State attorneys general have broad oversight powers but limited budgets and expertise in alternative investments. They tend to focus enforcement on other areas.

  • Plan actuaries provide critical analysis of pension finances but often use unrealistic return assumptions heavily weighted toward alternative investments. This obscures the true health of pension funds.

In summary, the various authorities and regulators have not provided effective guardrails against excesses and abuses in the private equity industry. This enables the continued high fees and questionable activities seen at many top funds. Stronger oversight and enforcement is needed to protect investors and beneficiaries.

  • Accounting authorities like FASB and GASB comply with the private equity industry’s desire for secrecy around fees and valuations. This leaves stakeholders like beneficiaries in the dark about true costs.

  • Fund managers have too much control over the valuation process for their portfolio companies. More independent third-party oversight is needed to ensure integrity.

  • PE databases take fund valuations at face value without independent verification. They fail to highlight the large proportion of unsold companies in returns or issues with IRR calculations.

  • The federal government has provided major tax benefits to PE funds for decades through the carried interest loophole, interest deductibility, and monitoring fees. These represent subsidies to the industry.

  • Nonprofit institutions like foundations and endowments pay substantial fees to alternative asset managers, raising questions about fulfilling their missions.

  • The SEC lacks adequate resources to properly oversee the large PE industry. The private nature of PE and supposed sophistication of investors leads to light regulation. More oversight is needed to protect investors.

  • Energy Future Holdings was the largest LBO ever at $45 billion, but it went bankrupt in 2014, wiping out $8 billion invested by prominent PE funds. This was one of several top 10 LBOs that failed.

  • Despite high-profile failures, PE funds have been able to raise hundreds of billions more from investors who dismiss the debacles and keep investing. The PE industry’s reputation for infallibility lives on.

  • PE titans have influential “fellow travelers” who help perpetuate the industry’s success by downplaying competing investment approaches, touting the PE model, and influencing pension funds and endowments.

  • These fellow travelers include business school professors paid as PE advisors, journalists getting scoops, and consultants recommending PE to clients.

  • Pension funds hire PE-friendly consultants who steer clients to PE and provide specious data praising results. Consultants are often angling for other PE business.

  • Wealth managers direct client money to PE to get allocations for their own funds. Many have a “you scratch my back, I’ll scratch yours” relationship.

  • This tacit complicity and influence network perpetuates the perception that PE is a superior investment despite mixed results on huge LBOs. The industry continues raking in money from institutional investors as a result.

Here is a summary of the key points from the passage:

  • The business media coverage of private equity (PE) falls into three categories: manager-oriented, stenography, and investor protection.

  • Manager-oriented reporting focuses on PE deals and personalities but provides little critical analysis. Stenography simply rehashes press releases. Investor protection incorporates some skepticism about PE methods and profits.

  • The traditional print media provides reasonably balanced PE coverage but stories tend to have a positive spin, inadvertently supporting the industry’s expansion.

  • Business television networks cover PE in a limited way, often just announcing deals or interviewing managers softly. They avoid tough questions to maintain access.

  • Trade publications and database services offer extensive PE industry news and data but shy away from scrutinizing performance.

  • A few bloggers cover PE in an educational way, not critically.

  • The growth of PE led institutional investors to expand in-house investment staffs and utilize investment consultants extensively. Consultants rarely challenge the consensus thinking on PE.

  • Endowments, foundations, and pension plans often hire outside investment consultants to advise them on asset allocation and manager selection. These consultants play a key role in promoting private equity to institutional investors.

  • Consultants provide services ranging from high-level portfolio strategy to selecting specific private equity managers. They rely heavily on a manager’s track record rather than conducting thorough due diligence.

  • Consultants often recommend large, established private equity firms based on brand name and scale over performance. Their endorsements lend credibility to the asset class.

  • Various service providers like law firms and accounting firms also promote private equity through informational websites and research reports.

  • Business schools have supported the growth of private equity through new courses, conferences, and research papers, though these tend to avoid critical examination of the industry’s performance claims.

  • Early academic studies concluding private equity outperforms public markets boosted the industry’s reputation. More recent studies are challenging this view.

  • Wealth managers cater to high-net-worth individuals interested in private equity, providing another source of capital for the industry.

  • The private equity industry has maintained a positive reputation and mystique for an unusually long time compared to other Wall Street investment fads like mortgage-backed securities and dotcom stocks.

  • This is partly due to the secrecy and complexity of PE data which makes it hard for skeptics to get clear evidence to challenge the industry’s claims about high returns and low risk.

  • There is a self-perpetuating feedback loop where PE managers make bold claims, pension funds and other institutional investors accept them, consultants recommend PE allocation, and regulators are hands-off. All these actors benefit so there is little incentive to question the status quo.

  • The PE industry has operated for 15+ years now with mediocre returns compared to the stock market, high fees, and questionable diversification claims. But the feedback loop preserves the illusion.

  • The losers in this system are the end beneficiaries of pension funds, universities, foundations etc. But the money managers, consultants, and other actors still get paid well, so there is no incentive to change.

  • The key question is one of priorities - luxury lifestyles for PE managers versus support for public pensions, scholarships, and charities. The system perpetuates the former over the latter.

  • The private equity industry has grown rapidly over the past few decades into a massive commercial empire with little accountability. Despite mediocre returns, PE firms have convinced institutions that investing in PE is essential.

  • PE returns are not as stellar as claimed. Median annual returns are around 8-9% based on funds’ own reporting. Market-beating PE funds seem to occur randomly rather than predictably.

  • PE managers are talented at obscuring their middling returns through confidentiality and spin. They have secured support from various third parties to further the industry’s unchecked growth.

  • Calls for reform of the PE industry are unlikely to succeed given its political and economic clout. PE firms will claim any new regulation will severely damage financial markets and innovation.

  • However, even Adam Smith did not advocate for entirely free markets without rules, especially when information asymmetry exists. PE firms benefit from such imbalances.

  • The PE industry focuses narrowly on business executives and owners. But workers, professionals, farmers, and others also have a stake in financial markets, though their interests often conflict with Wall Street’s.

  • Institutional investors charged with managing money for these individuals should be more skeptical of the PE industry’s self-interested claims and devote fewer dollars to PE given its questionable profit potential.

Here is a summary of the key points from the provided content:

  • The private equity industry experienced rapid growth in the 1990s and early 2000s, with a proliferation of new funds and increased allocations from pension plans.

  • Private equity firms use leverage to acquire companies, make operational changes, and then sell them for a profit. This leveraged buyout model can lead to large returns but also significant risk.

  • Top-tier PE firms have historically outperformed public markets, but most funds fail to beat basic stock indexes. There is debate around whether PE persistence is skill or luck.

  • High fees charged by PE firms are a drag on returns. Management fees are charged regardless of performance, while carried interest gives managers a cut of profits.

  • SEC oversight of private equity is light compared to public companies, leading to transparency concerns. Performance data can be cherry-picked and reporting manipulated.

  • The PE model has evolved from small buyouts to megadeals and huge funds, presenting challenges in deploying capital. Competition for deals has increased, possibly eroding future returns.

  • After a long period of strong returns, PE has struggled in the last 10-15 years. Returns have lagged public equities while risk has remained high. The PE model itself is being questioned.

Here are the key points summarizing the articles and studies on private equity performance:

  • Research finds private equity returns are overstated compared to public market equivalents due to valuation methods like mark-to-model. Returns appear less volatile than public markets.

  • Private equity returns have trailed public markets over the past 10-15 years according to several studies. Top quartile funds are overstated due to survivorship bias.

  • Financial engineering like leverage increases returns on paper but also risk. Higher default rates are seen in private equity owned companies.

  • Lower priced deals after recessions like 2008-09 produced better returns, suggesting timing and cyclicality are key.

  • Private equity provides diversification but may not reduce volatility as much as claimed due to co-movement with public markets.

  • Recent downturns showed private equity valuations change with public markets, despite smoothing and appraisal methods. Claims of low correlation are questioned.

  • Critics argue returns rely on distribution timing, fees, and benchmark ambiguity more than operational value-add. Market timing and financial engineering are bigger drivers.

Here is a summary of the key points from the article:

  • Private equity fund valuations and performance have come under scrutiny during the COVID-19 pandemic and market volatility. Private equity funds are difficult to value since they invest in private companies without readily available market prices.

  • Valuations are conducted quarterly and rely on estimates, projections, and subjective judgments. This makes them vulnerable to manipulation to boost performance.

  • Private equity returns have historically relied on leverage, multiple expansion, and fee waivers which may not be sustainable. There are questions about whether high returns can continue.

  • State pension funds, endowments, and foundations have plunged into private equity in hopes of boosting returns. But several studies suggest these institutional investors have underperformed simple stock/bond indexes even with alternatives.

  • Private equity fees are high, opaque, and layered. Management fees, monitoring fees, transaction fees and others can total 7-10% of committed capital over a fund’s life. There is little evidence fees lead to higher net returns.

  • Yale chief investment officer David Swensen pioneered the high allocation to illiquid alternatives for endowments. But most lack Yale’s resources and investment acumen, and have struggled to implement the strategy successfully.

Here are the key points from the referenced texts:

  • There is increasing debate about whether large institutional investors like public pension funds and university endowments should continue allocating substantial portions of their assets to alternative investments like private equity, hedge funds, and venture capital. Some studies suggest these alternatives underperform simple stock/bond portfolios.

  • Private equity in particular has come under scrutiny for high fees, lack of transparency, and questionable performance claims. Several states have sued private equity firms over fees and performance.

  • Public pension funds face political pressures that may influence their investment decisions, like choosing local private equity firms as managers. They lack resources to effectively oversee complex alternative investment programs.

  • University endowments also allocate heavily to alternatives, though their performance has lagged simple stock/bond portfolios. Endowments lack accountability and face little oversight.

  • The investment staff at private equity firms and investment consultants play a key role in maintaining the alternative investment model. They promote these investments and downplay the associated risks and costs.

  • Government regulators provide little oversight of alternative investing practices. Private equity firms use loopholes to minimize taxes and disclosure. More scrutiny is needed of this trillion-dollar industry.

In summary, growing evidence suggests institutional investors would be better off avoiding high-cost, opaque alternative investments and using simple, low-cost indexing strategies instead. But various political and financial incentives preserve the status quo.

Certainly there are a few key points we can summarize:

  • The book examines the lack of accountability and validity in leveraged buyouts (LBOs), pointing to issues like manipulable accounting metrics, self-reporting of performance data, and a lack of transparency around fees and valuations.

  • It argues that LBOs have been overhyped and oversold by a network of players including private equity firms, pension fund consultants, business media, and academics, all of whom benefit from the high fees generated.

  • The author contends that LBOs have not clearly demonstrated superior returns compared to conventional investing, despite claims to the contrary, and that risks and fees are underestimated.

  • The book calls for more accountability, transparency, and fiduciary duty in the LBO/private equity industry, to better serve pension beneficiaries and investors. It advocates for reforms like stricter regulation, auditing of self-reported data, and changes in pension fund governance.

In summary, the book makes the case that the LBO industry has dodged accountability and propagated myths about its performance and benefits, to the detriment of many investors and society. It argues for major reforms to bring more transparency, validity and fiduciary responsibility to this influential sector of finance.

Here are the key points I gathered from the summary:

  • LBOs and private equity firms have faced criticism for lack of accountability and transparency around fees, performance, and fiduciary duty. However, they argue returns justify the model.

  • LBOs became popular in the 1980s with the rise of junk bonds and developments like the RJR Nabisco deal. Institutional investors like pensions provide capital to LBO funds.

  • LBO fund returns are driven by high leverage, operational improvements to companies, and financial engineering. But academic studies show performance is mixed vs public markets.

  • LBO fund managers point to top quartile fund returns, but data shows persistence of returns is questionable. There are issues around manipulation of IRR and murky track records.

  • Critics argue LBO fund fees create misalignment with investors, as do practices like transaction and monitoring fees. There is limited oversight and disclosure around fees charged.

  • Overall the LBO industry argues it provides strong returns to investors based on the fund model and operational expertise. But concerns persist around lack of transparency, questionable performance data, and misaligned incentives.

Here is a summary of the key points about the performance, accountability, and validity of leveraged buyouts (LBOs):

  • LBO performance is difficult to assess accurately due to self-reporting of results, smoothing practices, and challenges in measuring returns like IRR. Many LBO performance metrics like TVPI and KS-PME are debated.

  • There is limited accountability for LBO performance, as SEC oversight is lacking and regulations are loosened. Self-reporting and smoothing practices reduce transparency.

  • The validity of the LBO industry is questionable, as performance claims are exaggerated by marketing, media coverage is inflated, and unsold assets can diminish returns. However, some argue validity is justified by diversification, bankruptcy rates, and fiduciary duty.

  • Fees charged by LBO fund managers are very high compared to other asset classes, confusing investors and potentially lowering net returns.

  • Overall, the lack of verified performance data, accountability, and doubts about validity suggest more oversight and transparency is needed to properly evaluate LBOs. Investors should be cautious when assessing advertised LBO returns.

Author Photo

About Matheus Puppe