Two decades ago, there was a consensus that private equity offered returns unmatched by the stock market.

But PE funds in the US have failed to outperform public stocks for at least 14 years, including one 10-year stretch in which the industry banked $230 billion in management fees on the promise of providing superior returns. Instead, those fees have turned into a massive transfer of wealth from LPs into the hands of a few buyout barons.

That, at least, is the conclusion put forth by Ludovic Phalippou, a financial economics professor at the University of Oxford's Said Business School, in a paper published earlier this month. The report is the latest recent instance of academic research that questions private equity's claims of outsized returnsthe very claims that have allowed funds to gather billions from pension funds, institutional investors and now 401(k)s.

Yet, limited partners haven't turned away from the asset class, healthy fundraising figures indicate. LPs committed a record-setting $315 billion to US private equity funds in 2019, according to PitchBook data. From 2010 to 2019, the annual dollar amount of private equity commitments increased fivefold.

Hilary Wiek, a Pitchbook analyst focused on fund strategies and performance, doesn't expect studies like this one to affect fundraising. Since private fund returns can vary widely, so too do investor experiences, she said.

"Many LPs believe that they have the ability to select top-tier managers, who will do quite a lot better than the industry overall," Wiek said. "So evidence has a lower impact on the behavior of private market investors than might otherwise be the case. It is too easily explained away if the beliefs are strong."

The private equity industry, of course, has a very different take on Phalippou's research: Rebuttals by Apollo Global Management, Blackstone, KKR and The Carlyle Group attached to the paper offer several detailed critiques, taking issue with everything from the underlying data used and carry calculations to assumptions about risk and comparisons to the S&P 500. Blackstone noted a 2020 survey in which 87% of LPs said that returns from PE "either met or exceeded their expectations."

But Phalippou isn't the only researcher concluding that private equity has lost its edge. In February, a report co-written by Harvard economist Josh Lerner and Bain & Company's Hugh MacArthur reached similar conclusions to Phalippou's. And a 2015 paper from Robert Harris, Tim Jenkinson and Steven Kaplan found that US PE investments outperformed the public markets up until 2006 but that since then, the gap has vanished.

"For the past decade, US public equity returns have essentially matched returns from US buyouts, which (to put it mildly) is not what PE investors are paying for," Lerner wrote.

Other reports have painted a muddier picture. In a paper published last October, Lerner and five co-authors concluded that the financial after-effects of a buyout can vary greatly depending on deal type, timing and several other factors, indicating that a one-size-fits-all approach to analyzing performance may not be ideal.

Phalippou and other researchers suggest one reason fundraising has soared while returns have stalled is the widespread use of internal rate of return as a measurement of PE performance, a metric that researchers assert can be easily manipulated and which often doesn't provide an accurate measurement of capital being returned to investors. Other measures, such as TVPI and multiple of moneythe latter of which is the main measure used by Phalippoumay be more difficult for firms to inflate and easier for LPs to understand, since they don't rely on the arbitrary timing of cash flows.

"Something large PE firms have in common is that their early investments did well. These early winners have set up those firms since inception IRR at an artificially sticky and high level," Phalippou wrote. "The mathematics of IRR means their IRRs will stay at this level forever, as long as the firms avoid major disasters."

Despite its opacity, investors continue to flock to private equity. Philappou says this is in part because the livelihoods of industry insiders, especially consultants, rely on the simple "fact" of PE funds superseding public markets. He describes this belief as a "quasi-religious article of faith."

"Merely to question it is considered heresy: Either you believe and you are one of us, or you question the existence of outperformance and you are an enemy," he added.

True, when looking at performance measures such as PME, US public markets have outperformed PE over the past decade, according to Wylie Fernyhough, a private equity analyst at PitchBook. But other metrics are more favorable, he said, including average revenue growth, where PE-backed companies have outstripped the S&P 500.

Fernyhough also noted that private equity performs better in down or flat markets, compared with public equities, which thrive in bull runs. For most of the timeframe addressed in Phillapou's report and other recent research, the world economy was in the midst of a bull market of record duration. Blackstone also questioned the chosen timeframe in its rebuttal.

But against the backdrop of a pandemic, the market seems unlikely to soar in upcoming months and potentially years. And if valuations begin to plateau across public and private, PE will likely outperform, Fernyhough said.

Featured image via MirageC/Getty Images

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