Last November, the $1.6tn Norwegian sovereign wealth fund asked the government for the umpteenth time if it could be allowed to invest in private equity. That’s a good excuse to explore one of the financial world’s most controversial issues.
After all, this is potentially a big deal, given the size of Norges Bank Investment Management and its status as the world’s biggest and broadest de facto index fund. The proposal is to move gradually to a 3 to 5 per cent allocation, which would mean almost $80bn — roughly the equivalent of a TPG, Warburg Pincus or General Atlantic.
But to make the effort worthwhile, NBIM would probably over time target a 10 per cent allocation (even this is about half of what many other comparable large long-term investors aim for). At the fund’s current size that would mean a $160bn slug of money — equal to the entire private equity arms of Blackstone, KKR, or Carlyle. No wonder several have been making trips to Oslo lately.
Moreover, the pros and cons of private equity have become increasingly pertinent, and hotly debated. Almost every major institutional investor in the world is investing more and more in private equity — it has become the go-to strategy for any pension plan struggling to hit its targets — but some experts argue the higher returns are a mirage, and even some insiders admit they are probably going to decline.
The Norwegian government is going to reveal its own views later this month, and then it’s up to parliament. Only 1/4 of FT Alphaville takes a special interest in anything Norwegian, and probably even fewer readers. But given the wider implications, NBIM’s desire to add private equity to its mandate is a good excuse to do a deep dive into the $5tn subject.
Private equity’s genesis moment
In October 1978 a tiny obscure investment company called Kohlberg Kravis Roberts bought Houdaille Industries, a venerable, publicly listed car parts maker that had worked on the Manhattan Project, for $380mn.
At the time it was considered remarkable: a large public company was being taken private by a bunch of nobodies, using massive amounts of debt that the acquisition itself was responsible for repaying. “Investment bankers, everyone, looked at us and said ‘KKR, what is that, a delicatessen?’” one former executive recalled in the book Barbarians at the Gate. Jerry Saltarelli, Houdaille’s CEO, hadn’t even heard of the term “leveraged buyout” until he got the call from KKR.
In some form, leveraged buyouts had been around for ages — for example, Jay Gould controversially borrowed aggressively to acquire and consolidate American railway and telegraph companies in the 19th century. But KKR’s Houdaille deal was the first that showed just how ambitious even a small investment company could be, and became a blueprint for the embryonic private equity industry.
The public documents on the deal’s details became widely read and dissected by envious Wall Streeters. One of them was a young and ambitious investment banker called Stephen Schwarzman, who had been made a partner at Lehman Brothers that same month.
Schwarzman, like many of his rivals, marvelled at the audacity of KKR, the structure of the deal, and the money that could be made. As he later said in King of Capital, a book about his subsequent founding of private equity giant Blackstone:
I read that prospectus, looked at the capital structure, and realised the returns that could be achieved. I said to myself, ‘This is a gold mine’. It was like a Rosetta Stone for how to do leveraged buyouts.
The returns that could be made from leveraged buyouts became an open secret a few years later when an investment firm called Wesray bought Gibson Greeting Cards — which owned the rights to Garfield the cat, among other things — for about $80mn in 1982.
Wesray only put up $1mn of equity and borrowed the rest. Its listing less than two years later had a value of $290mn. As a New York Times headline on the deal said: “Reaping the big profits from a fat cat”.
Ever since, the promise of eye-watering returns has enticed pension plans, endowments, insurance companies, private banks and business tycoons to pump $5tn into the industry.
Many happy returns
That shines through in the rationale that the Norwegian sovereign wealth fund laid out in its letter to the Norwegian finance ministry in November asking for permission to include private equity in its investment mandate.
At first it discusses how companies are staying private for longer, which NBIM says is becoming a growing problem for a public market investor of its size. After all, it already owns about 1.5 per cent on average of every major listed company in the world, and the number of public companies is shrinking.
As Laurens Swinkels, a finance professor at Erasmus School of Economics and a former senior researcher at NBIM, told Alphaville, the simple fact was that “companies don’t want to be listed any more”.
You can wonder whether that’s socially desirable or not, but if companies want to stay private then maybe the investment strategy has to be adapted to reflect that. If you basically want an index fund that is broadly invested across the world, you’re actually missing out on a swath of potential returns. The stock market isn’t as representative of the global economy as it used to be.
Indeed, the real concern is that investment returns are migrating from increasingly mature public capital markets to racier private markets, not that NBIM’s ownership might become more concentrated. After all, the number of public companies may be falling, but their size is increasing faster.
From NBIM’s letter, with Alphaville’s emphasis below:
A small proportion of listed companies are accounting for an ever larger share of the listed equity market. The number of listed companies worldwide has levelled off. Since 2010, the listed equity market has not grown beyond what can be explained by movements in share prices. There are fewer IPOs in developed markets, and the companies coming to market are larger than before. This suggests that the GPFG is missing out on part of companies’ growth by not investing until after they have been floated and eventually enter the fund’s equity benchmark. These trends are not new but have become more pronounced over time.
A quick aside to explain the GPFG reference. That stands for Government Pension Fund Global, the name of the actual fund (often just called “the oil fund” in Norway, or Oljefondet). It is managed by NBIM, which is part of Norges Bank, the central bank, because only it had the requisite investment expertise through reserve management when NBIM was first set up in 1996 and initially only invested in bonds.
NBIM and Norges Bank report to the finance ministry which, in turn, answers to the government. The ultimate decision on what to do regarding private equity will go to parliament, however.
And here’s the crux of why NBIM wants to get into private equity:
The goal for the management of the fund is the highest possible return after costs. Analyses of historical returns indicate that investments in private equity could give higher returns after costs than listed equities in the long term. The fact that the GPFG is a large, long-term and well-reputed investor gives reason to expect a higher net return than for the average investor in private equity.
On returns, NBIM cites CEM Benchmarking, a Canadian firm that collects data reported by $15tn worth of pension funds, endowments and other sovereign wealth funds. It found that the average annual net return of private equity has been 4 percentage points higher than what its clients have made on public equities over the past decade.
This meshes with longer-run data from Cambridge Associates, a big US investment adviser that collects quarterly unaudited and annual audited financial statements produced by private equity funds for their investors.
As Ken Bloomberg, the co-head of private equity at Dutch pension plan APG, told Alphaville:
It’s been a positive experience for APG’s clients when you look at it from a long-term perspective . . . On the whole, our PE program has delivered strong returns that have exceeded other asset classes and its public market equivalents.
The ‘yes, but’ section
There are lies, damned lies, and investment return statistics. There are many ways that returns can be angled to make someone look great or bad, inadvertently or deliberately.
That is particularly true for internal rates of return — the private equity industry’s own favoured measure of how much money it makes for investors. As Antti Ilmanen, global co-head of portfolio solutions at AQR Capital Management notes, IRRs “have got lots of problems. They are popular but they are dangerous, very misleading.” At the same time, costs are opaque and complex, and don’t just stop at the classic 2 per cent management fee and 20 per cent of profits. Even large institutional investors sometimes have a hard time figuring out exactly what they’re paying.
As a result, over the years there have been many papers by reputable academics that come to more nuanced conclusions on the industry’s returns.
One of the first broadsides against private equity was Steven Kaplan and Antoinette Schoar’s Private Equity Performance: Returns, Persistence and Capital Flows. Published by the Journal of Finance in 2005 it sensationally argued that returns were roughly similar to that of public equities after adjusting for the eye-watering fees.
Kaplan and colleagues Robert Harris and Tim Jenkinson were then handed a hoard of private equity fund performance data from consultants Burgiss. In 2012 they published a new paper that estimated returns had exceeded public markets for “a long period of time” and by a healthy margin — more than 3 per cent per year on average.
But in financial academia, little remains settled for long.
In 2013 Andrew Ang, Bingxu Chen, William Goetzmann and Ludovic Phalippou caused a stir by arguing that “private equity is, to a first approximation, a levered investment in small and mid-cap equities”. Then in 2020 Phalippou, a professor of financial economics at Oxford’s Saïd Business School, brought a gun to the fight.
Phalippou, whom Institutional Investor has dubbed “the bête noire of private equity”, published an incendiary paper titled An Inconvenient Fact: Private Equity Returns & The Billionaire Factory. As you might expect from the title it pulls zero punches, calculating that the only people to do well out of it (on average) are the private equity tycoons themselves.
. . . While the PE industry can play a positive role for society, it is unlikely to be sustainable if it continues to allow some participants to present arguably window-dressed performance information and incomplete fee information.
One reason why this sustainability question has not been central yet is that the facts highlighted in this paper have not been exposed to, and admitted by, most market participants. In a complex environment riddled with multiple layers of agency conflicts, misleading information can and does proliferate. The result is a highly inefficient and unfair equilibrium. The absence of a level playing field encourages a race to the bottom in terms of misleading information.
Only facing facts, disclosing all relevant information, having level playing rules, better education, and simplified structures can bring a superior overall equilibrium. This superior equilibrium, however, will probably generate fewer billionaires.
So why is it so hard to figure out whether private equity makes sense — at least from a financial perspective?
Benchmarking fun and games
One seemingly simple but in reality major problem is simply what benchmark you choose to compare returns with. In the case of CEM, its data is solid and credible — the actual results of its 500-plus clients — but the comparisons made are often apples-to-pears for several reasons.
As Phalippou told FT Alphaville:
We all basically agree what the returns of private equity are. What we disagree on is what benchmarks to use . . . I’m always amazed by the sloppiness of the reasoning of some of the people advocating for private equity. And some of them are my friends.
💥 First, the public equity portfolios of institutional investors are probably some kind flavour of global equities, while private equity on average has a heavy US skew.
The MSCI All-Country World index is a decent proxy for most institutional stock portfolios, and a decade ago the US weighting was 47.7 per cent — high, but far from the probably ca-80 per cent of private equity dollars that have been invested in the US.
This tilt towards the US would have been an incredible tailwind over the past decade in particular. The MSCI ACWI returned 8.48 per cent annualised in the 10 years to the end of 2023, while the MSCI USA index returned 11.98 per cent. But even since the index’s inception in 1987 US equities have outperformed global ones by almost 2 percentage points a year.
So comparing a US-tilted private equity industry to a broad global equity portfolio after a period of staggering outperformance of American assets is unfair. Maybe it will continue, but it seems like a gamble to count on it.
💥 Second, the average private equity portfolio doesn’t look much like the public equity market in terms of the typical size of companies or their industries — aspects that also should be addressed for an accurate like-for-like comparison.
That private equity typically tilts towards smaller companies is a point in the industry’s favour, at least more recently. The S&P 500 is often used as the default comparison because of its ubiquity, but, in reality, it’s a poor benchmark for private equity returns given how top-heavy it is.
It is interesting to see how the Russell 2000 small-caps index has in recent years become a more popular benchmark to showcase private equity returns — which no doubt has nothing to do with its weak performance since the financial crisis . . .
💥 Third, averages and annualised rates hide all sorts of gremlins, and private equity is no different. Various studies indicate that private equity returns were better in the ’80s and ’90s, when it was much smaller and there was less competition. So longer-term return estimates are flattered by the big wins notched up ages ago (a prominent phenomenon in hedge funds as well).
Moreover, smaller, more specialised funds that just focus on one specific industry tend to do much better than bigger, broader funds. According to Mantra Investment Partners, niche funds have average returns of 38 per cent over the past decade, roughly twice as good as the results of the private equity industry as a whole.
And yet most money is actually being raised by generic LBO megafunds, which can then market themselves using return averages they are dragging lower. For investors the size of NBIM, the only practical option is these LBO megafunds, not smaller specialists where the returns are on average better.
💥 Finally — and probably most importantly — the returns of public equity markets are un-leveraged. In contrast, leveraged buyout funds use, well, a lot of leverage to generate their returns.
KKR’s 1978 Houdaille acquisition — as close to a genesis moment as you’ll find for the modern private equity industry — is a good example. KKR reportedly only ponied up $1mn of equity for the $380mn purchase, the rest being borrowed by the company itself to pay for its own takeover (in the US and many other countries, this debt is de facto state subsidised by tax breaks on interest payments).
This was extreme. Private equity firms have to write far bigger cheques these days. PitchBook LCD estimates that the average equity contributions last year crossed the 50 per cent threshold for the first time since it began to track this data in 1997.
Moreover, it’s not like non-private equity owned public companies don’t borrow money either. But they are relatively less leveraged. So you cannot honestly compare directly the performance of public and private equity without taking leverage into account.
So what does an apples-to-apples comparison look like? The best paper on this is probably Jean-François L’Her, Rossitsa Stoyanova, Kathryn Shaw, William Scott, and Charissa Lai’s paper “A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market”, things look different if you adjust for leverage, size and industries to get apples-to-apples comparisons.
Alphaville’s emphasis below:
Using a bottom-up approach, we identify the systematic risks of underlying companies in buyout funds to inform an appropriate risk-adjusted benchmark, which we determine to be a levered size- and sector-adjusted public index. After making these risk adjustments, we find no significant outperformance of buyout fund investments versus the public market equivalent on a dollar-weighted basis.
Even one of the overarching review studies that NBIM itself cites — Risk And Return in Private Equity by the University of Southern California’s Arthur Korteweg — indicates that “when additional risk factors are accounted for, the net-of-fee risk-adjusted performance of both VC and buyout is lower, in many cases insignificant and in some cases negative”.
Another recent paper by Richard Ennis — one of the doyens of US investment consulting — also concluded that there was “no support for the proposition that private equity has added value to pension fund returns in the post-GFC era” (while hedge funds and real estate “significantly” hurt returns).
Private equity’s brave new world
It is important to remember that NBIM and other large institutional investors are buying private equity’s future returns, not its historical record. And there are a lot of indications that returns are going to be much lower in the coming decades.
💥 First, the industry is far larger today, and is sitting on an astonishing $2.59tn of capital it is struggling to deploy. There’s therefore more competition for the sweetest deals, “pass-the-parcel” LBO fund-to-LBO fund transactions are becoming more common, and returns will inevitably be eroded.
The days when a private equity firm could easily snap up some big lumbering conglomerate trading at bargain prices and carve it up for a profitable piecemeal sale are over. As our MainFT colleague Mark Vandevelde has written, today’s lumbering conglomerates are arguably the private equity firms themselves.
💥 Second, one of the dominant factors behind overall private equity returns over the past four decades was declining interest rates. That has now gone into reverse.
Debt is the primary fuel that powers the private equity engine, and between the early 1980s and the 2020s, the cost of that fuel haltingly fell to zero. As a result, even bad deals could be rescued by refinancing at cheaper and cheaper rates, and mediocre ones turned into cash cows to be milked through dividend recaps.
Moreover, four decades of falling interest rates helped increase corporate earnings and swell equity market valuations. Indeed, a Federal Reserve paper published last year estimated that lower interest expenses and tax rates explain almost half of all growth in US corporate profits between 1989 and 2019. At the same time, valuations of those earnings streams have increased because of lower discount rates used to calculate their worth.
Despite private equity insisting that they improve companies, Bain’s latest report on the industry estimates that “nearly all the value creation” in private equity-owned companies between 2012 and 2022 actually came from revenue growth and multiple expansion. “Margin expansion barely registers,” the consultancy noted drily.
With interest rates now higher and unlikely to return to zero — though they’re unlikely to return to the 1980s highs either — the private equity golden era is almost certainly over. Even if central banks begin to trim rates, the scale of the decline from the early ’80s will never be replicated.
As Jeffrey Jaensubhakij, the chief investment officer of Singapore’s sovereign wealth fund GIC (one of the oldest and biggest private equity investors in the world), told the FT last year:
Many of the things that were tailwinds for the private equity industry have come to an end . . . and I don’t think they are coming back any time soon.
Of course, average results are always going to be, well, average. So what if average private equity returns fade from here? The trick is to invest only with the best firms and to somehow limit the cost of private equity — which is substantial and can be a major drawback on net returns.
But is this feasible?
Making private equity work for investors
Let’s examine the first point. In mutual funds that invest in mainstream public markets, the persistence of performance is historically weak-to-negative. In other words, if a fund has a good run, the chances are greater that it is about to do badly.
That means it is very difficult for investors to consistently pick winning portfolio managers, even from the ranks of those with already superlative long-term track records.
How does private equity stack up? Well, Kaplan and Schoar’s 2005 paper highlighted nearly two decades ago that there was “substantial persistence” in the performance of private equity funds.
General partners (GPs) whose funds outperform the industry in one fund are likely to outperform the industry in the next and vice versa. We find persistence not only between two consecutive funds, but also between the current fund and the second previous fund. These findings are markedly different from the results for mutual funds, where persistence has been difficult to detect and, when detected, tends to be driven by persistent underperformance rather than over-performance.
However, more recent studies indicate that the persistence of private equity fund performance is weakening, and since 2000 there is “little evidence” of it, according to a 2020 paper by Harris, Jenkinson, Kaplan and Ruediger Stucke.
That makes investing in private equity funds more of a crap shoot. Large investors such as NBIM will hope for some of that sweet alpha, but should probably expect nothing better than the average after-fee performance.
Things look a bit better regarding the second point on controlling costs. There are actually a few levers investors can yank to try to enhance their net returns.
The main way (big) investors can ameliorate the drag from the high fees charged by private equity firms is to use their heft to negotiate discounts, and to set up internal investment teams that do co-investments alongside the LBO fund sans fees.
For example: if Generic Greek God Capital is buying Widgetmaker Inc, 70 per cent of the equity it ponies up might come from one of its LBO funds. One of the fund’s own investors — Gulf Investment Authority, say — then covers the remaining 30 per cent. GIA would only pay fees on the money it has invested in GGG Capital’s actual fund, and thereby in practice secure itself a big discount, and perhaps more exposure to Widgetmaker’s revolutionary new widget.
For pension plans like APG — which has almost $50bn of its $563bn assets in private equity — co-investments have been a major reason why it is so happy with the results. As Bloomberg says:
It’s an expensive asset class, and we try to mitigate this by using our size to get fee discounts and incorporating a robust in-house co-investment programme . . . With co-investments we also get to double-dip on companies we really like, ones with a positive ESG or impact mission. It’s a way to effectuate more change for the good.
Co-investments (and in some cases direct investments) have become far more prevalent in recent years, as Canadian, Australian and European pension plans have followed the path first taken by a few sovereign wealth funds.
No wonder. While CEM Benchmarking estimates that internally managed private equity portfolios on average do slightly worse than the industry as a whole, the cost saving “far outweighs any difference in top line return”.
A robust co-investment programme is certainly central to NBIM’s pitch:
Large investors, such as the GPFG, may have better access to the best managers, a better bargaining position and a greater capacity to co-invest with them.
. . . Our costs will probably be lower than for the average investor, both through lower fixed management fees and better access to co-investments where no fees are normally paid.
However, there are some problems here too, some of which are admittedly specific to NBIM.
💥 First, NBIM’s mandate stipulates a cap on external manager compensation to avoid politically unseemly obscene windfalls from managing Norway’s money. This would have to be “adjusted” as NBIM admits that it is “unlikely that a private equity fund will accept a limit on fees”. (lol)
💥 Second, NBIM is not the only big investor that thinks it can extract better terms out of private equity firms. In reality it will be competing for dealflow with the likes of Temasek, the Qatar Investment Authority or Canada’s CPP Investment Board. And given the amount of capital going into private equity, fee discounts aren’t going to be huge.
💥 Finally, a good co-investment programme requires large in-house teams of private equity specialists that can assess deals and monitor companies, in addition to all the normal due diligence on private equity funds.
NBIM argues that it has “considerable experience” in choosing investment managers in public markets, but the reality is that this does not translate well into private equity. For example, APG’s own private equity team is almost 50 people, or circa one person per billion dollars.
For NBIM this might mean building an even bigger team from scratch, at salaries far higher than what it has historically paid. This might be tricky in egalitarian Norway — in 2022 chief executive Nicolai Tangen took home just $676,000, roughly the average salary at Blackstone — and in a fund that is proud that its management costs are just 5 basis points annually.
The illiquidity fairy
Of course, another major reason so many investors stick with private equity — even if they don’t have access to top managers, have the heft to negotiate less onerous fees or set up in-house co-investment programmes — is private equity’s lack of volatility. At least of the traditional kind.
Because private companies don’t trade like stocks on an exchange, private equity funds only do modest quarterly valuations and firmer annual ones. These can often be more art than science. That means that there’s a lot of scope for smoothing out returns, making them look both better and gentler than those derived from stock markets.
Perhaps they don’t go up as much in a rally but they often stay steady in a bear market — a welcome cushion for institutional investors, even if it is just an artifice of accounting rules.
This doesn’t get talked about too loudly. A lot of investors in private equity prefer to justify their large and growing allocations with a reference to a mythical creature called the illiquidity premium, a fairy that apparently sprinkles private markets with its magical return-enhancing dust.
Around the chalets of Switzerland and Hamptons watering holes they will exchange stories of how this illiquidity premium fairy must exist to reward patient investors for investing in untraded assets. Doing so is obviously risky, and the laws of investment dictate that taking on a risk must be rewarded with a risk premium. For an investor like NBIM, this is a particularly enticing story. As the ultimate large, liquid, long-term investor it can harvest an illiquidity premium til the cows come home.
Unfortunately, like most investment stories, it’s a myth. Investment laws — like returns and risks being commensurate — are not laws of physics. With so much money going into private equity, any theoretical illiquidity premium has arguably morphed into an illiquidity discount.
As AQR Capital Management’s Cliff Asness has argued, given that illiquidity is actually an attractive feature of private equity rather than an undesirable bug, it probably comes at a cost:
Liquid, accurately priced investments let you know precisely how volatile they are and they smack you in the face with it. What if many investors actually realize that this accurate and timely information will make them worse investors as they’ll use that liquidity to panic and redeem at the worst times? What if illiquid, very infrequently and inaccurately priced investments made them better investors as essentially it allows them to ignore such investments given low measured volatility and very modest paper drawdowns?
. . . What’s the next implication of extreme illiquidity and pricing opacity being a feature not a bug? Well, you pay up in price (and give up in expected return) for features you value (not bugs you can’t stand). Attractive smoothness of returns may not come for free. If illiquidity is more positive than negative to many investors, it could easily mean paying a higher price and accepting a somewhat lower return to obtain it.
That’s not irrational. And whatever academics say, it’s hard to ignore the fact that a lot of big institutional investors have chosen to allocate more and more money to private equity. Some might be doing so gormlessly, but most are smart, rational people who are aware of the more nuanced performance data. They do so for a reason.
No one is really harmed by the fake smoothness of private markets, and at least the private equity industry can plausibly promise (if not guarantee) greater returns than public markets, even if it mostly boils down to leverage and some sectoral skews.
Tony Robbins is certainly a believer.
What should NBIM do?
Unfortunately, smoother returns is not a killer feature to NBIM, which has weathered immense drawdowns in the past without any real stress or public opprobrium.
If public markets halve in value then NBIM will halve in value — which in nominal dollar terms will look apocalyptic, given its size — but if there is little to no return compensation for taking illiquidity risk then it doesn’t make sense to take it. If NBIM wants to increase its exposure to private equity, the easiest way would be to simply nudge up its stakes in the likes of Blackstone, Apollo, KKR, Carlyle, Brookfield, EQT, Ares and Partners Group — all of which it appears to be underweight or absent from.
NBIM also has other unusual considerations that should make politicians wary of expanding its mandate. Private equity’s often-cited lack of transparency is actually a pretty weak counterargument — there are ways it could be overcome — but the industry’s occasionally rough tactics and sensitive target industries are a poor fit for a fund indirectly owned by 5mn highly opinionated Scandinavian social democrats.
Getting into private equity could therefore risk undermining the remarkably broad popular support for NBIM’s existence, management and investment style.
Yes, it has evolved dramatically since its inception in 1996 — first adding equities in 1997 and gradually increasing the allocation to the current 70 per cent, and including real estate and renewable energy infrastructure in the mandate in 2010 and 2020 respectively.
However, the overarching model of cost-conscious, overwhelmingly passive, diversified and radically transparent public market investing with some ethical guardrails set by parliament has remained constant.
It is hard to see how that can easily be reconciled with becoming a sizeable private equity investor. As Erasmus’s Swinkels notes:
The beauty of NBIM is keeping things simple. There’s beauty in simplicity, especially when there are political considerations. There’s overwhelming popular buy-in to how the fund is managed now. That’s very valuable, and shouldn’t be lightly discarded.