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April 18, 2024
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Private Equity

How Ludovic Phalippou Became the Bête Noire of Private Equity


When 22-year-old Ludovic Phalippou landed in Los Angeles in 1998 to pursue a PhD in economics at the University of Southern California, the new world he encountered left him with what can only be described as culture shock. Descended from several generations of farmers in a tiny village in Southwest France, he barely spoke English. Some members of his family had not finished high school. Phalippou himself had been able to attend the Toulouse School of Economics only because it was nearby — and free. Fortunately, the school had ties to the University of Southern California, and soon after graduation, Phalippou found himself on a plane traveling some 6,000 miles from home.

“All of a sudden, I was not the son of a farmer who people would look down to and not take seriously. I was just a white male, which tends to be a favorable condition,” he recounted in a recent interview in New York City, where he was meeting with academics at Columbia Business School and speaking to legal scholars and regulators at a private forum on the future of private equity regulation. In an insouciant tone, Phalippou acknowledged that he had another advantage: a French accent, which is “totally cool.”

The young economist soared to the top of his class at USC, where professors told him of the many lucrative career opportunities available for someone with his talents. “My first reaction was ‘I can’t. There’s no way I can do these things.’” But, he notes, “no one cares here. It doesn’t matter. The world was open, and that was completely new for me because in France it would’ve been totally closed.”

As a graduate student, Phalippou says, he was tutoring other students and “making tons of money.” If he gave a three-hour tutorial on Saturday morning to 20 people, “Boom, there was $1,000 on my table. It’s like, ‘What’s that?’” he recalls in amazement.

Phalippou was quickly discovering that just about anything is possible in the land of free markets. Unbridled capitalism — coupled with what he would come to believe was incredible American naiveté — would eventually take him all the way to Oxford University’s Said Business School, where he is now a leading academic teaching the complex financial machinations of private equity to MBA students. His lectures, full of wry humor as well as obscure facts, have made Phalippou a pop star among students, who call him Professor Ludo.

“When I tell them all the tricks to be careful about and how people get rich out of nothing by [using those] tricks, I do have a third of the students who say, ‘That’s great. I learned from Ludo how to do it,’” he says.

Not surprisingly, Phalippou has also become the bête noire of private equity, which he has deconstructed in academic research dating back to 2003, when he first learned that “data point after data point . . . I found that virtually everything sold as a fact was not quite so,” he writes on his website, pelaidbare.com. His ten academic articles on the subject have together been downloaded nearly 100,000 times and cited more than 4,000 times. First published in 2017, Phalippou’s textbook, Private Equity Laid Bare, is in its third edition.

The professor’s fame exploded in 2020 with a blockbuster paper titled “An Inconvenient Fact: Private Equity Returns & the Billionaire Factory,” which laid out how the asset class has created massive fortunes for the owners of private equity firms. Phalippou calculated that the $230 billion these owners earned in performance fees on funds raised between 2006 and 2015 alone had created 22 multibillionaires by 2020 — up from three in 2005.

Phalippou calls it “money for nothing.”

He found that in recent years private equity funds offered their investors just about the same return as could be made putting money into broad stock market indices — but with much higher costs, which he figures come to 7 percentage points of gross return in both management and performance fees. And that number does not include the extra monitoring and transaction fees sometimes charged to companies owned by a private equity fund’s investors. In an October 2014 video that is his most widely viewed lecture, Phalippou reveals the $200 million in transaction fees paid to Apollo Group and TPG for their 2008 buyout of Harrah’s Entertainment (since renamed Caesars Entertainment), whose later bankruptcy led to a contentious battle with lenders over those fees.

In his lecture, Phalippou “translates” the complicated management services agreement in his typical fashion, explaining that the legal jargon means “I may do some work from time to time,” “I do some work only if I feel like it,” and “If I do decide to do something, I charge you extra.”

Not surprisingly, the backlash against such irreverence has not been pretty. “The reaction of people usually is, “This guy is going to give us trouble,” Phalippou says.

Leading private equity firms KKR, Apollo, and Blackstone Group disputed some of his analyses in lengthy responses, which he included in his “Billionaire Factory” paper. Yale University’s endowment threatened him with possible legal action (but never took any), and conferences have canceled his speaking engagements at the request of well-heeled sponsors, according to Phalippou. But the “meanest of them all,” he says, was private equity firm Hamilton Lane, which Phalippou says ridiculed him in a way that made him so angry he looked into suing them. (Hamilton Lane denies Phalippou was the specific target of its criticism of academics.)

“He doesn’t buckle,” notes Nate Koppikar, who worked at TPG and later founded hedge fund Orso Capital. “He’s completely unafraid of them.”

Phalippou’s critiques have not slowed the private equity asset-gathering machine, which now boasts more than $4.4 trillion. Recently, however, there have been tremors, even if they’re mostly a function of the markets. Fundraising is down, firms have been unable to unload their portfolio companies at a profit, and high interest rates are beginning to take a toll on their heavily indebted holdings.

But predicting the industry’s demise is not something Phalippou is willing to do. In part that’s because of the many people in pension funds and endowments, not to mention consultants, whose careers depend on private equity’s existence — and who are not investing their own money. Then there are what he calls the “tricks” the industry uses, like buying up insurance companies to invest in its own funds or keeping investors on board by coming up with continuation vehicles to house their best assets.

“‘Everything’s going well. It’s fine,’” mimics the 47-year-old Phalippou, running his fingers through a shock of hair, now flecked with gray. “It’s wild.”



Even as a child,

Phalippou says, he was “obsessed” with numbers and data. From the age of eight, he “would follow the Tour de France. Because I couldn’t afford newspapers, I would get all newspapers from a neighbor and then keep track of the ranking and the evolution of each person on the ranking.” Growing up on a farm, he also created a game using corn kernels as playing pieces to model economic growth.

The math whiz’s rise to private equity nemesis was part serendipity — and part French. Despite his enchantment with America as a land of opportunity, Phalippou says, “I was not totally happy with being in Los Angeles. I was a little homesick.”

From a visiting professor at USC he learned about INSEAD, a business school located outside Paris, which he says “is totally U.S.-minded.” But “I can get my cheese and my bread.” (His birthplace, Villefranche de Rouergue, is near Roquefort-sur-Soulzon, home to the famous cheese. His father also worked as a baker to supplement the family farm income.)

Phalippou moved back to France in 1999 and enrolled at INSEAD, switched his PhD focus from macroeconomics to finance, and soon met a former consultant also studying there who said he had access to data on a “very hot asset class called private equity. Of course, I’d never heard of it,” he recalls.

The former consultant said few academics were doing research on the new asset class and suggested the two collaborate. At the time, investors were relying on consultants for information on private equity. After looking at a few prospectuses managers used to raise money, Phalippou was fascinated.

“I could see the selected investments, I could see the way they were presenting things, how it was distorting the picture. And so very early on I was like, ‘People seriously send that to investors and they will invest just because they think they’re going to become rich?’”

For example, he says, the footnotes would say, “This is the track record of the existing team.” And I was like, “So they fire the people who have bad investments and then that’s the track record of the existing team?”

Through his fellow INSEAD student, Phalippou also gained access to private fund legal documents, which was rare for academics at the time. The documents gave managers a surprising amount of latitude. Phalippou notes that once an investor signs a contract with a private equity fund, it has “a lot of discretion as to how much [the fund] can charge, which is quite odd.”

At the same time Phalippou was learning about private equity through these legal documents, the mutual fund late-trading scandal of the early 2000s was unfolding. In some cases, asset managers were allowing investors to circumvent rules and buy a mutual fund that invested in public securities after the close of the market and still get that day’s price. Phalippou believed that similar “tricks” favoring some clients could very well happen in private equity and suspected that co-investments and portfolio company fees could be an effective channel for this.

“Back in 2003, no one had thought about any of that, let alone discussed it publicly,” he says. “It was basically impossible to publish academic papers on this issue because there was no hard proof and very few academics even knew about these things.”

Phalippou was driven to find out what was going on in part because of his upbringing. “It is very European to question wealth, to be suspicious of wealth,” he points out. That was a contrast to what Phalippou had experienced in the U.S., where a “positive mindset” about money was “refreshing,” but also dangerous. “Europeans find the Americans often quite naive, in the sense that everything is positive. Somebody sends them a 200-page legal document, they assume that it must be all right.”

Phalippou says his motivation for studying economics is to understand “why some people are much wealthier than others” and whether the wealthy are “clearly smarter or they’re just cheating.” As he puts it, “That really gets me hooked, and I can spend nights and days finding out how they cheated.”

Looking at the private equity prospectuses while at INSEAD, Phalippou seized on one data point: annualized internal rates of return of more than 30 percent. They seemed too good to be true. “Already at the time, I had a suspicion around IRR. But I hadn’t got it yet.”

The deconstruction of the flaws in the calculation of IRR, which is commonly used to measure the performance of private investments, would eventually become one of Phalippou’s major contributions to the academic research. The professor began publishing his critiques in 2004; his first findings on IRR methodology came out in 2008.

“He was an iconoclast, a forward thinker,” says Jeff Hooke, a former private equity executive who is now a senior finance lecturer at Johns Hopkins Carey Business School. “He was a lone voice crying out in the wilderness from an academic point of view because at that point, ten years ago, the assumption that private equity beat the public markets was settled law, as they say in the legal business.” (To be sure, private equity became popular because it did outperform the stock market in the 1980s and into the 1990s.)

The problem Phalippou identified is that it’s simply impossible to measure a rate of return when things are not continuously traded like stocks. The process for calculating the values isn’t standardized. “You need a computer to solve a pretty complex math problem to do it,” he notes.

As an example, he says, “If you bought a house for $1 million, you made some additional investments of $500,000 every year, and then you sold it for $10 million after five years, what’s your rate of return on this? You could say, ‘Oh, let me add up all the investments I made in the house.’” But after five years, the rate of return on the investments made in the first years is not the same as on those made later, he explains.

Private equity funds measure IRR by assuming the returns on sales of portfolio companies made early on will be available for the rest of the fund’s life of eight to ten years. That incentivizes certain behavior. “You make sure you exit your winners quickly,” Phalippou explains.

IRRs also can be manipulated with strategically timed cash flows, he argues. The increasingly popular subscription lines — credit extended to a portfolio company owned by a fund early on to avoid drawing down investors’ committed capital and to boost return on equity, make IRR calculations “an absolutely ridiculous thing,” he says.

At first, private equity did significantly outperform public markets. In a report published in June 2021, Michael Cembalest, the chairman of market and investment strategy at J.P. Morgan Asset Management, included data showing that average U.S. buyout fund IRRs peaked in the early 1990s at more than 30 percent.

He calls Phalippou’s research “very well done.” That research found that funds launched from 2006 to 2015 — when many institutions got in or ramped up their allocations — returned about the same as relevant public market equivalent indices.

The only way to determine the actual return of private equity is by seeing what an investor gets back at the end of a fund’s life. According to Phalippou’s research, large public pension funds have received a net multiple of money, another measure of performance, that sits within a narrow 1.51-to-1.54 range. The big private equity firms have delivered estimated net MoMs within a similarly narrow 1.54-to-1.67 range.

Those net MoMs imply an 11 percent annual return, which Phalippou says matches the performance of publicly traded stocks during the same period.

Many funds report IRRs similar to those of public markets. But there are outliers. “This year, I put a LinkedIn post congratulating KKR for the 25th year in a row having a 26.3 percent return,” quips Phalippou, saying the number is that high because KKR’s early investments were highly profitable. “But logically, it makes no sense. Most people would understand that it means that if I had given $1 to KKR when they started in 1976, every year I would have accumulated 26 percent” annually, he explains. “That would mean a $1 million investment in 1980 would be worth about $100 billion. It’s not the case, by miles.”

In a statement to Institutional Investor, KKR says, “We are proud of our long track record of investment excellence, and we are confident that our investors have the requisite information to understand the performance of the funds and strategies they are invested in. We have also publicly disclosed detailed performance information for each of our seasoned funds that make up our 47-year inception-to-date IRR and accompanying inception-to-date multiple on invested capital.”

Phalippou notes that another way private equity firms make the returns look better is to change the benchmark against which a fund is compared. “It is easy to pick a public equity benchmark with low returns,” he writes in “The Billionaire Factory.”

In the paper, the professor explains that “the standard choice of benchmark used to be the S&P 500 Index. Now it is the MSCI World Index, or the MSCI All Country World Index, which includes emerging markets. Another common benchmark is the Russell 2000 Index.” Those indices typically have much lower returns than the S&P 500, the research shows.

The finding that private equity’s outperformance has been largely determined by the benchmark used has been widely replicated by other academics, Phalippou says in “The Billionaire Factory.”

His analysis has also been confirmed by new research, which shows that the benchmark a pension uses tends to change after it brings in new external consultants. As II recently reported, researchers have found that these changes often lead pensions to choose benchmarks that are easier to beat than the measures they had been using.

In recent years, the lack of outperformance of private equity compared with the stock market as first exposed by Phalippou has gained credence with other prominent academics — notably Josh Lerner, a professor of investment banking at Harvard Business School, and Antoinette Schoar, a professor of finance at the MIT Sloan School of Management.

In an email, Schoar says that “there are times when [venture capital private equity] outperforms and others when it underperforms public markets. But we also show that there are big differences between different GPs, and some consistently outperform, others underperform.” Lerner did not return a request for comment. In “The Billionaire Factory,” published in 2020, Phalippou writes that “the last year has seen an avalanche of practitioner reports confirming that average PE returns are similar to those of public equity.”

But only a few allocators have taken the message to heart. More than a decade ago, in 2011, Phalippou was hired by the Norwegian Parliament to analyze its $1.5 trillion sovereign wealth and pension fund. In his report, he says, he told the Parliament “everything there is to know about private equity.” He answered questions about corporate governance issues, reputational risks to the Norwegian government, how past returns compared to public equity, risks, and fees. “I can read this report 12 years later now, and it’s spot on,” he says.

Norway’s Parliament decided against investing in private equity.

And in 2018, Phalippou was asked by Pennsylvania’s state treasurer to analyze the state’s two main pension funds, the Public School Employees Retirement System and the smaller State Employees Retirement System, which were facing underfunding issues following years of poor performance. Phalippou examined fees, costs, and the performance of the funds and determined the pensions had underreported fees paid to private equity firms by one-third over the previous decade.

PSERS was a case study in exactly the type of issues Phalippou had been highlighting in his academic research. The pension fund had a higher allocation to alternative investments than any other pension fund — more than 50 percent higher — but its returns failed to beat the broader market.

By November 2021, a scandal engulfing the fund forced two of its senior executives out amid a Department of Justice and Securities and Exchange Commission investigation over the misreporting of returns, among other concerns. (Since then, PSERS has lowered its target allocation to private equity to about 30 percent, according to a report in The Philadelphia Inquirer.)

The scandal also dragged in the pension funds’ consultant, Hamilton Lane. In 2017, PSERS gave the company a $7 million, five-year contract to help find alternative investments, noted the Inquirer, which said “its goal, according to Hamilton Lane’s more than 1,000-page contract, was to achieve ‘superior’ returns compared with ordinary stocks.”

Hamilton Lane joined PSERS in 2019 in lobbying to stop a legislative effort to compel it to more fully disclose private equity fees and performance, the Inquirer reported. (In 2021, a Pennsylvania teacher sued Hamilton Lane over its role, saying it had been “grossly negligent” in its advice. The company declined to comment on the case, which is ongoing.)

“Hamilton Lane are probably the people who are most annoyed by my stuff,” Phalippou asserts. He says the firm mocked him in a presentation at its annual meeting in 2021 with a cartoonish character called “Professor Pluto Haddock,” which was also mentioned in its annual report. “They made this guy a complete lunatic who doesn’t know numbers and facts,” says Phalippou, adding that Hamilton Lane also suggested that “I was available for hire” and that “if you give him money, it would change his mind.”

Says a Hamilton Lane spokesperson: “Mr. Phalippou incorrectly assumed that our humorous take on this collective academic perspective was about him specifically. It is not. Professor Pluto Haddock represented a generic version of the various academic perspectives against the private markets industry.” Phalippou looked into legal avenues to sue Hamilton Lane, but determined that U.S. libel laws would make that impossible given that he is a public figure. The high cost of suing in Europe also stopped him from doing so.

“I’m still quite upset about it, but it’s okay. That’s life,” he says.



There are two ways

of interpreting Phalippou’s seminal work, says Dan Rasmussen, a former private equity executive whose hedge fund, Verdad Capital, includes strategies that replicate the asset class. “One — which is the way a lot of people on Wall Street read it — is ‘If it’s a billionaire factory, it must be pretty damn good.’ And then the way Ludovic wrote it, which is ‘It’s pretty bad.’”

Private equity has been controversial since the nonfiction bestseller Barbarians at the Gate described the contentious effort by KKR to take over RJR Nabisco in 1988 in one of the largest leveraged buyouts ever. Since then, private equity has drawn public scorn for loading companies with debt and laying off workers, causing high-profile bankruptcies.

Last year, two books came out detailing private equity’s outsize role in health care, retail, nursing homes, housing, and prisons, to name a few industries where it has a huge and — according to the authors’ investigations — deleterious presence.

Perhaps surprisingly, Phalippou says that’s not the whole picture. “You also have plenty of cases where private equity made the company work much better. So the overall picture is mixed, slightly negative but mixed.” He also stresses that “I am not anti-PE; I am pro-LP, basically. If LPs were presented with lower fee bills, their investment in PE would be fair.” (Phalippou has a French cycling jersey emblazoned with the letters “LP.”)

At any rate, the asset class is entrenched in the American investment world. Between 2021 and 2022, private equity funds raised more than $706 billion in the U.S., according to the American Investment Council, the industry’s lobbying group, which says that the industry directly employs 12 million people and is responsible for 6.5 percent of U.S. GDP.

Private equity also remains the hottest home for pension funds, endowments, and sovereign wealth funds. In fact, such investments have skyrocketed over the past decade.

“Ludovic has been criticizing private equity over a period where [institutions] have taken their PE allocation up from 10 percent or 15 percent to 30 percent or 35 percent,” says Rasmussen. “There’s been zero influence of these types of criticisms of private equity in terms of actual dollar allocations.” He thinks this is shortsighted. “People are taking a big, big, big bet that Ludovic’s wrong. I think he’s right.”

Phalippou is sanguine about the industry’s continued growth. According to him, there has been little incentive for institutional investors to bolt. He attributes their inertia to a myriad of agency conflicts inherent to the asset class.

“Investors are not playing with their own money,” explains Phalippou. “That’s very important. If you are working for a pension fund, you give me a completely cooked number that says that I invested in you and you gave me a 40 percent return. I go to my board of trustees and say, ‘I walk on water.’” He notes that some LPs are even getting compensated as a function of IRR.

As Phalippou puts it in “The Billionaire Factory”: “Why are trustees, investment teams, external managers, consultants not seeing through this? Maybe because their livelihood depends on them not seeing it, especially for consultants. Net-of-fee performance of PE funds being superior to that of public equity is the sine qua non condition for continued employment of at least 100,000 people. The importance of this condition might explain why the mantra of ‘PE outperforms’ has, for many people who work in and around PE, become 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.”

Even though there are powerful incentives for allocators to continue investing in private equity, the strategy’s fundraising fell off a cliff in the first part of last year, declining by about 40 percent during the first six months to about $156 billion, according to PitchBook. The reasons for that reflect some of the asset class’s challenges.

Private equity firms must raise new funds every couple of years to keep the flywheel turning, and they have relied on investors in previous funds to pony up for the new ones. But those allocators don’t have the cash to do that if they’re not getting distributions back from their earlier fund investments, which is exactly what created a logjam last year.

The problem is at least partially related to how private equity firms mark their holdings, a process that itself has come in for criticism over the past year as the funds’ returns didn’t fall in tandem with the publicly traded markets. The upshot is that many private equity funds weren’t able to sell these overvalued portfolio companies at a profit. Last year, PE firm exits came to only $574.2 billion, a 26.6 percent year-over-year drop and the lowest value since 2012, says PitchBook.

“They don’t get the exits,” Phalippou says, shrugging. Moreover, the unwillingness to mark down investments has created a “denominator effect.” As public equity portfolios collapse in value, the private equity allocations become a bigger portion of the pie. He elaborates: “The paradox is, because you want to pretend you’ve been doing well, now you look to be such a large part of someone’s portfolio that they cannot give you more money.”

As one way around this conundrum, private equity firms have been looking for other sources of capital, for instance buying insurance companies, which they say provide permanent capital because of the constant inflow of premium income. Apollo was the pioneer of this strategy, since adopted by others.

“Often I think that I have a pretty tilted mindset,” Phalippou admits. “And I think I have quite a wild imagination in trying to see how [PE firms] can game stuff. But a few times, they have surprised me.”

The purchase of insurance assets would be one of those surprises. Phalippou is skeptical about private equity firms buying or taking stakes in insurance companies and then managing some of their balance-sheet money for a fee. According to the Financial Times, insurance regulators are starting to look into the risky deals PE insurance money is going into.

Apollo did not return multiple requests for comment.

Another device the industry is using in the current environment is continuation funds, or GP-led secondaries, in which a private equity fund takes a promising investment out of a fund nearing the end of its life and puts it into a new vehicle. These funds have been around for a while but are becoming even more popular.

Phalippou explains that a PE firm gets an incentive fee when a fund that invested in, say, ten deals does well with those ten as a unit. But a continuation fund takes the most successful investment and plops it into a new fund. Investors that opt into the new fund will pay a higher performance fee on the single-best investment, instead of possibly not having to pay a performance fee if the other companies in the original fund do poorly and the average return is below the hurdle rate that private funds have to beat.

“You’re creating a massive conflict of interest,” Phalippou says. “[Investors] are going to effectively pay a higher fee overall for these assets.”

Over the years, the SEC has tried to rein in some of private equity’s more egregious behavior, like the fees charged in the controversial Harrah’s buyout. By 2018, four years after Phalippou’s lecture about their “money for nothing” fees, TPG and Apollo paid millions of dollars to settle SEC charges related to the monitoring fees payable by portfolio companies. Since then, private equity firms have largely abandoned the practice, says Phalippou. (TPG and Apollo neither admitted to nor denied the SEC’s allegations.)

More recently, SEC chairman Gary Gensler made a stab at reform with new rules aimed at increasing transparency in fees, among other issues. The reforms require a registered private fund adviser to distribute a quarterly statement to investors that includes performance, the cost of investing in a fund, fees and expenses paid by the private fund, and certain compensation and other amounts paid to the adviser.

The rules also mandate that a registered private fund adviser obtains a fairness opinion or a valuation opinion when offering existing fund investors the option to convert their holdings into what amounts to a continuation fund. Further, the rules take a crack at monitoring the valuation of such assets, forcing firms to disclose any “material business relationships” the adviser has had with the independent opinion provider during the previous two years.

The SEC argues that such a requirement “will provide a check against an adviser’s conflicts of interest in structuring and leading such transactions.”

Phalippou is unimpressed, saying the rules are “very mild.” He summarizes them this way: “I’m going to ask you to please do what you have always told me you are doing. The private industry always said, ‘But we tell everything to our investors. We tell them the fees.’ Now the SEC comes and says, ‘Can everybody please do that?’ And they say ‘Oh, my God, you are overstepping. I’m going to sue you.’”

On September 1, the Managed Funds Association and a group of private equity and hedge fund trade groups did indeed sue the SEC over the rules, filing the case in a Texas federal court. A group of institutional investors recently pushed back, filing an amicus brief supporting the rules. Phalippou expects the case to eventually land at the U.S. Supreme Court, where the conservative majority will rule against the SEC.

It’s enough to make a Frenchman shake his head and say, “Wow.”



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