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How Private Equity Could Fail
2022 Market Review

John Gorlow | Jan 24, 2023

This month we begin with a wrap-up of 2022, a painful year for investors. Then we introduce you to a hidden risk of which you may be unaware—the precarious condition of private equity markets. “There is no good idea that too much money can’t destroy,” wrote Ruchir Sharma in a December opinion piece in the Financial Times. We’ll lift the lid on the private equity engine to take a look inside. First, a look at the numbers.

Examining the Wreckage

Markets tanked in 2022, turning in the worst returns since 2008, when the collapse of Lehman Brothers was followed by the Great Recession. The S&P fell 19%, the Dow Jones Industrial Average dropped 8.8%, and the Nasdaq Composite declined 33% as tech shares imploded. The broad MSCI All World index of developed and emerging market equities lost more than $30 trillion, or nearly 20% of its market value.

Bonds got thrashed as well. The yield on the 10-year U.S. Treasury note, which affects mortgage rates, credit card rates, and student debt, climbed to 3.83% from 1.50% at the end of 2021. As yields rose, the U.S. bond market fell 13% by year-end 2022.

How did things take such a bad turn? In short, investors and policy makers made the wrong bet on inflation, which everyone hoped would be transitory. Instead, the inflationary match struck in 2021 became a blaze in 2022.

Other factors added to price pressures, including snarled supply chains and Russia’s invasion of Ukraine, which sent oil and gas prices soaring and stoked fears of global food shortages.

Inflation continued to rise even as oil prices moderated, climbing from 7% year-over-year in December 2021 to 9.1% by June 2022. Compelled to action, the Fed embarked on the most aggressive quantitative tightening since the 1980s, raising interest rates seven times over the course of the year.

Against this backdrop, the economy demonstrated resilience. Employers kept hiring, and by December 2022 the unemployment rate had dropped to 3.5%, the lowest since February 2020.

2023: More of the Same?

Unfortunately, the issues that sapped markets in 2022 are still with us. But today fears of recession have been displaced by fears of inflation for global business leaders. Most economists now predict a recession, with some expecting it to materialize by mid-year.

Recent hawkish comments from Fed Chairman Jerome Powell and other central bankers have made it clear that the fight against inflation isn’t over, and a recession may be the result.

Fed tightening is having an impact. U.S. inflation data shows that the Consumer Price Index declined for the sixth consecutive month in December, for an annual increase of 6.5%. This marks the lowest inflation since October 2021, and a notable decline from 9.1% reached in June. The report sent stock and bond market indexes higher in the new year.

The Bloomberg Global Aggregate index, a broad gauge of global fixed income, rallied more than 3% so far this year after falling more than 16% in 2022. January results, month-to-date, put the bond market on track for its biggest January return on record since 1991. Separately, the U.S. bond market rallied over 7% from its October low. These gains, driven by a big rally in longer-term government debt, are an early vindication for advisers who encouraged clients to maintain duration in their bond portfolios in late 2022 to avoid being whipsawed by excessive volatility.

In foreign stock markets, Europe's economy showed signs of resilience, with European stocks roaring back to life boosted by signs of slowing inflation, falling energy prices, and optimism surrounding China's reopening.

Emerging market equities rallied over 20% from an October low as easing global inflation and hopes for slower U.S. interest rate hikes caused the asset class to soar.

The market’s optimism is like a ray of sunshine that may soon disappear. Economists warn that while a big fall in energy prices has bolstered prospects for 2023, underlying inflation will keep pressure on central banks to continue tightening.

The risk for the Fed is that it may pause rate hikes while the economy is still accelerating, the exact opposite of what it did last year when boosting rates during a slowdown. Imagine this: the Fed pauses, markets rebound, the economy picks up, and inflation makes a big comeback. Not what anyone wants to see, which is why a mild recession may in fact be the best outcome for investors.

A recession may already be on the doorstep. Retail sales and producer prices declined more than anticipated in December, and production at US factories also fell more than expected. Signs of a cooling economy are a reminder that monetary tightening comes with an economic cost.

Volatility is likely to continue and investors should expect it. But markets have already priced in lower valuations and other uncertainties. When good news appears, only those who remain invested will benefit from the rapid shift in sentiment.

A Hidden Risk That You May Have Missed
How Private Equity Could Fail

This article excerpts from a variety of sources, noted at the end. We are particularly grateful for a 2020 paper by Professor Ludo Phalippou, who was one of the first to shed light on the holes in private equity valuations.

After nearly a quarter century of reeling in investors and creating billionaires at the top, private equity (PE) investing may be approaching bubble territory. Today this lucrative arm of the financial industry has grown into a juggernaut accounting for nearly $10 trillion invested in debt, private companies and real estate. What you might not know is that the PE industry is under stress, challenged by rising interest rates, a faltering tech industry, and a possible recession on the horizon. Even if you’re not a private equity investor, it may be hard to escape the impact if the industry falters or collapses.

Private investing was first popularized in the early 2000s by the Yale Endowment Fund led by the late David Swensen. The idea was to create multi-generational wealth by investing privately through astute managers who could build and nurture companies for the long-term rather than stripping and flipping them for a quick profit. By removing the pressures of short-term thinking, Swensen’s approach also promised to free money managers from the pressure cooker of market expectations, quarterly performance and volatility.

It was a brilliant idea whose time had come. Then the financial industry got its jaws around it. And private equity investing, with its emphasis on long-term results, turned out to be one of the very best ideas of all time for enriching folks at the top while eliminating the pesky requirements of reporting and transparency.

By November 2022, the private equity industry had created 37 billionaires with a reported collective net worth of $180 billion. Compare that to just three private equity billionaires in 2005. Among the names on the list of billionaires are leaders of the big four private equity firms, including Leon Black (Apollo), George Roberts (KKR), Henry Kravis (KKR), David Rubenstein (Carlyle), and Stephen Schwarzman (Blackstone).

How did these people get so wealthy? Among other things, private equity (PE) firms make money from fees, including incentive fees, and “carried interest” (Carry) for providing investment management and other services to their funds. Carried interest is a share of profits earned by the PE companies on third-party invested capital. The fraction charged is almost always 20%, and is paid as a fraction of absolute performance, rather than relative performance. The hurdle rate, meaning the minimum rate of return on a project required by a manager before they can participate in the carry, is almost always 8% per year.

Upon Closer Examination

The popularity and eye-popping success of private equity begs for an explanation. But understanding PE results has been difficult as industry data is extremely hard to come by. This absence of data is compounded by the PE industry’s bulwark of defense which flows through its marketing, sales and consulting teams to some of the world’s wealthiest investors, endowments and pension funds. Critics of the industry are often dismissed as “unsophisticated investors.” And as the industry has grown and flourished, one can imagine the intense pressure to either fall in line or risk losing out on a great opportunity. Hence, it is likely that most private equity investors rely on information fed to them by industry consultants and salespeople, rather than on objective analysts.

Troubled by an industry that receives compensation far in excess of levels justified by the value created, one tenacious Oxford professor pulled back the curtain for a peek inside. In “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory” Professor Ludo Phalippou (Financial Economics, Oxford University, Said Business School) examined how much “Carry” PE firms collect compared to how much value they deliver relative to public equity benchmark indexes (Journal of Investing, December 2020).

Phalippou relied on data from private capital back-office fund administrators including, among others, Burgiss and Preqin, widely viewed as the most accurate providers of cash flow data, especially for North American PE funds.

The problem in a nutshell: No one knows exactly what the actual Carry figures are, since Carry is not reported in the fund administrator cash-flow data sets, and public PE firms don’t break it out. But working with fund administrator cash-flow data and cross-referencing his research with publicly listed PE firms (Apollo, KKR), along with large public-employee retirement system disclosures from states including California, Washington, Pennsylvania, Florida and Oregon, Phalippou was able to break it down.

To tease out PE returns, he calculated the ratio of total capital distributed per funds in the Carry plus net Asset Value, divided by the total amount of capital paid in. This ratio is called the “Multiple of Money” (MoM) invested. Then he converted the “MoM” into an average annual rate of return and benchmarked these returns against public equity index returns.

Phalippou’s research shows that the MoMs he calculated, and comparable MoMs derived from SEC PE Industry filings and State Pension Plan disclosures, each averaged about 1.5. This corresponds to a 10.7% per annum return for PE funds, which is generally no different than relevant buy-and-hold returns on public equity indices, a result confirmed by using Net Present Value (NPV) and Public Market Equivalent (PME) calculations. This data shreds the myth of outperformance. PE funds returned about the same as public equity indices.

How much are investors paying for what is basically standard performance? To calculate how much Carry is being charged by the PE funds, Phalippou subtracted total net value (distributed capital plus NAV) from total paid-in-capital for all funds in the Carry. This helped him get to net profit, that is, the profit after the Carry is retained. To determine the Carry, he grossed up net profit by 20% as is customary practice in the industry.

As noted earlier, Carry is paid on absolute rather than relative performance. Although the PE funds in the study (2006-2015 vintages) returned about the same as public equity benchmarks (about 11% per annum), PE managers still received $230 billion of Carry, along with many other fees. Most of this money went to relatively few individuals, including founders of large PE firms (Source: Ivashina and Lerner, 2019).

One large fund for which Phalippou collected fee and expense details generated 1.5x capital invested. For a total fund size of $10 billion, the cost to investors was $1.4 billion of Carry and $1.4 billion of other fees (management fees, expenses, portfolio company fees). How could this be an economic model that works, Phalippou wonders. The private equity model, especially in the Leveraged Buy-Out (LBO) segment, is an absurdly costly form of financial intermediation.

PE and Peer Pressure

Certainly, most PE investors will not read Phalippou’s study. Even a few paragraphs of summary as presented above is enough to make the head swim. Imagine the resources the PE industry is willing to employ to rebut these findings. It becomes “Believe them, those crazy academics with their misguided data, or believe us.”

An industry of more than 100,000 people has been built on the PE story of success. To fall out of line and suggest that PE is not wizardry but a great scheme that reaps unimaginable fees could be a career-ending move, especially if you’re a person entrusted to safeguard enormous wealth. Little wonder that trustees, investment teams, external managers, consultants, CIOs and boards of directors all have strong motivation to believe that “PE outperforms,” even if it doesn’t. Imagine a pension fund board admitting paying billions of Carry to achieve the same returns as public equity markets. There is huge potential downside and no career upside for such an assertion. And if the board room is packed with PE acolytes, good luck. One could say that the industry has done a very, very good job of achieving buy-in.

Truth With a Twist

PE has an army of defenders, decked in data to deflect criticism and obfuscate the issues. The audience for these rebuttals includes doubters but is aimed equally at investors who have questions.

As Phalippou reminds us, the main rule when pitching sophisticated investors is that one cannot lie. But there are many ways to present information in a way that leads to a false conclusion without telling untruths. An often-heard rebuttal regarding average return is that the Yale Endowment (Yale) and analysis of private equity firm performance proves that investors can earn outstanding returns in PE. The reason is the use of Internal Rate of Return (IRR) to measure and report performance. IRR is the annual rate of growth that an investment is expected to generate. But it can be highly misleading when applied to periods of high returns.

For example, consider this footnote in Yale’s 2017 annual endowment update: “Over the past twenty years, the venture capital program has earned an outstanding 106.3% per annum return. Yale’s 106.3% venture capital return over the past twenty years is heavily influenced by large distributions during the Internet boom.”

Since such a calculation assumes reinvestment of proceeds from the portfolio during the period at the same rate of return for the rest of the period, it is inappropriate to compound the 106.3% return over the 20-year time horizon. For reference, the 20-year time-weighted return of Yale’s venture capital portfolio is reportedly 25.5%.

Phalippou points out that the time-weighted return is not a useful measure either in this case, because the returns are skewed; the period probably includes one or two years with a return of 100% or more. The most informative measure of performance would be a Multiple of Money invested (MoM) or a Public Market Equivalent (PME) calculation. Despite being repeatedly queried, Yale has yet to communicate these common measures, he wrote.

In fairness to Yale, they seem to have updated their performance presentation framework. Here is the phrasing on performance from their endowment update for 2021. “The endowment’s investment return during Swensen’s thirty-five-year tenure averaged an unprecedented 13.7% per annum.” A record to be proud of, to be sure, but less remarkable when benchmarked over the same period against 12% per annum returns for the S&P 500 Index, 12.56% returns for the Dimensional US Large Value Index, and 14.11% returns for the Dimensional US Small Cap Value Index. In other words, a low-cost, broadly diversified systematically structured equity portfolio, simultaneously targeting widely accepted value, size and profitability premiums, would have captured the same result as the Yale endowment with less risk, far fewer resources and without sacrificing liquidity.

Unfortunately, many in the PE industry continue to gaslight the marketplace with their performance presentations.

Founded in 1990, Apollo Global Management presents itself as follows in its 2021 10K filing: “As of December 31, 2021, we have consistently produced attractive long-term investment returns in our traditional private equity funds, generating a 39% gross IRR and a 24% net IRR on a compound annual basis from inception through December 31, 2020.”

Similarly, KKR states in its 2021 10K filing: “From our inception in 1976 through December 31, 2021, our investment funds with at least 24 months of investment activity generated a cumulative gross IRR of 25.6%, compared to the 12.1% and 9.5% gross IRR achieved by the S&P 500 Index and MSCI World Index, respectively, over the same period, despite the cyclical and sometimes challenging environments in which we have operated.”

Again, keep in mind the mathematics of IRR, and the fact that IRR is not a rate of return. And remember that large PE firms often had early investments that did very well. Early winners have established these firms’ since-inception IRR at an artificially sticky and high level. The mathematics of IRR means IRRs will stay at this level forever, providing the firms avoid major disasters.

Consider, for instance, the absurdity of a 39% return in the case of Apollo’s claim by compounding it. An investment of $100 million in 1990 compounded at 39% per annum would be worth $2.3 trillion today.

The use of such a measure of performance may seem surprising in an SEC filing, but it is standard practice. The same is true for many private documents created for so-called “sophisticated PE investors.” These investors, courted by the wealth management industry, see private equity and venture capital as their primary value proposition. They have drunk the Kool-Aid, so to speak, and have become loyal to an industry that has filled their glass.

The most common counter-argument from the industry for continuing to promote misleading IRR statistics is that investors can detect distortions by comparing IRRs and MoMs. And yet this argument holds no water, as MoMs across the big four PE firms (Apollo, KKR, Blackstone and Carlyle) net of Carry are nearly identical to the average in the Burgess universe (net of all fees), and the averages match the return of relevant stock market benchmarks.

David Swensen, the late CIO of the esteemed Yale endowment, pointed to the obviously lopsided value equation some 20 years ago: “Paying 20% of the profits to the general partner instead of 20% of the value-added drives a meaningful wedge between the result for the general partners and limited partners. Poor incentive schemes cause PE fund managers to benefit by placing limited partner assets at risk, creating an extraordinarily valuable option for the general partner that comes at the expense of the capital providers of the funds.”

Swensen added that “If private manager compensation depended on generating returns in excess of marketable investment opportunities, most would fail to receive a profits interest, as results for the majority of private funds fall short of traditional equity alternatives.”

The Diversification Fallacy

One common claim of PE marketers is that their funds offer superior diversification. But evidence points to quite the opposite.

Using fair value reporting, Kyle Welch (Harvard, Jan 2014) shows that data provided by PE firms overstates performance and understates the economic co-movement between PE returns and market returns.

All else being equal, the lower the co–movement of an asset within a portfolio, the more important it becomes to the portfolio to allocate to the asset. By making PE assets seem less correlated with public market alternatives, PE firms are able to make the false claims that they deliver higher returns with less risk.

Why does it matter? The illusion of a diversification benefit created by using PE reported returns can lead to misallocation of capital, higher risk, and underperformance. This is all hidden from the investor.

Swensen raised similar concerns in 2009, elaborating on the implications of using accounting information for risk assessment of illiquid private equity assets. “Illiquidity masks the relationship between fundamental drivers of company values and change in market price, causing private equity’s diversifying power to appear artificially high…. Private compan[ies] gain spurious diversifying characteristics based solely on lack of co–movement with the more frequently valued public company.”

The Brilliant Manager Myth

Investors often confuse great wealth with investing brilliance. They want the very best money managers. Private equity perpetuates the myth that their managers are the cream of the crop. They recruit managers who have performed well in the past, managing so-called top-quartile funds, and avoid first-time funds. Investors want to believe that top-quartile performance in PE persists across successive funds, but this conventional wisdom has been debunked many times in PE and other investments. The latest research shows no evidence of persistence in top-quartile PE funds.

Why Investors Don’t Seek Change

By now, PE is so embedded in major investment funds that to question the veracity of its performance data is to open oneself to a barrage of criticism. But to live with the idea that not all facts are known, or that performance data may be hidden or obscured, can be equally uncomfortable.

Why don’t those invested in PE read reports like Phalippou’s and demand lower fees based on net MoMs? The answer may be that PE is built on many layers of principal-agent conflicts of interest. PE employs thousands of well-paid professionals. Acquisitions require a stable of lawyers, consultants, advisers and accountants to analyze companies from every angle, design business plans, and create complex corporate structures to minimize tax bills, among other things. Post-acquisition, there may be more work required of consultants, investment bankers, and PE firms.

It all adds up to a staggering amount of money spread around an enormous industry. According to Phalippou, to raise and invest $200 billion, PE funds charge at least $70 billion in due diligence, legal costs, organizational and fund expenses, plus Carry. Absent an increase in valuation, PE equity would have to double in value every four years just to break even with public market equivalent returns.

Thus far, the industry has had a great run of luck. Over the past two decades, valuations did increase and a lower earnings growth could then accommodate a doubling of equity value. But going forward, it is likely to be far more difficult to achieve these same results. If large, mostly fixed costs were just about covered in a high-return, low interest rate environment, outcomes will likely pan out very differently in a low-return, high interest rate market.

What Could Go Wrong?

Recall the inception and original intent of PE: Swensen and other pioneers bought low in private markets and sold high in public markets. But today’s private managers, flush with new funds from asset allocators worried about diminishing returns in public markets, are chasing deals. They’re buying high and hoping to sell even higher, running up record debt in the process, according to reports by Sharma and others. In lieu of exiting investments, PE companies increasingly hand off portfolio companies to their next funds, in effect constructing a giant pyramid or Ponzi scheme.

Sharma points to troubling trends:

• The typical company owned by a private equity firm has debts of more than five times its earnings, versus one to three times for publicly traded companies.

• Today, nearly 100% of the loans private funds use to finance buyouts are “covenant lite”—that is, condition free—up from about 0% a decade ago.

• Investors are piling into private deals as the market for initial public offerings evaporates. Many of the late arrivals are retail investors, a classic bubble warning.

• No matter where PE firms invest their money, all companies, public and private, face the same serious challenges of slowing growth, rising interest rates, and inflation.

You’d expect to see cracks in the façade, and yet the gulf in valuations persists. According to Lincoln International, a private fund adviser, the enterprise value of firms held by private-equity funds globally rose 1.9% in the third quarter of 2022, leaving them up 3.2% for the year to date. The S&P 500, by contrast, fell 22.3% in the same period.

Private investing has an array of tricks to cover its tracks. Public markets are repriced daily and publicly, while PE firms trade quarterly at most, and then opaquely. Valuation work is kept in-house, with only about a quarter of PE firms seeking outside opinions. Today some managers borrow money to do deals instead of calling for investors’ capital right away, another trick for artificially boosting a fund’s internal rate of return.

But as long as the reported numbers look good, there is little incentive to resist, even as the risk of heavy losses increases. “How long can the illusion last?” Sharma asks. You can expect PE managers to drag it out. After all, during the bursting of the dotcom bubble in 2000, it took American venture-capital managers nearly half a year to report impairments after public markets peaked. A cynic might imagine that period as an intense six months of behind-the-scenes machinations to set the ship right. It took even longer after equities crashed in 2007. And then, PE investors were saved by rock-bottom interest rates and a recovery that began in 2009, just in time.

Fast forward to our current time. More than a year has passed since the peak of the tech-heavy Nasdaq Composite and subsequent steep losses. The cash holdings of some private firms are eroding, leaving little for return-smoothing financial engineers to work with. In August 2022, Masayoshi Son, the boss of Softbank Group, predicted private valuations would rejoin public-market ones within a year to 18 months.

More recently, a limit on withdrawals suggests investor uneasiness with an eye on the exit sign. KKR is the latest investment manager to limit withdrawals from a PE fund. Blackstone Group imposed curbs after a surge in redemption requests from PE clients in December. These redemption caps underscore the risks investors have taken on by investing in PE funds. How many read the fine print?

Without a 2009-style recovery in public equities in sight, a downgrade almost certainly looms. In a house built on heavy borrowing, secrecy, and huge payouts to top investors, it can be hard to guess when and which PE firms will falter, and how many investors will be burned. One thing is certain: private markets are far more vulnerable at this point than public markets. They are not a good place to be for any investor unwilling to shoulder enormous risk.

As always, if you have questions or concerns about your portfolio or asset allocation, call me. I am here to help.


John Gorlow
Cardiff Park Advisors
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760.635.7526 Direct
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1. How private markets became an escape from reality (Financial Times, Ruchir Sharma, 18-December 2022)

2. Has private equity avoided the asset-price crash? (Economist, 31-December 2022)

3. Private markets are more likely to deflate than implode in 2023 (Financial Times, Katie Martin, 13-January 2023)

4. “An Inconvenient Fact: Private Equity Returns & The Billionaire Factory” by Professor Ludo Phalippou (Financial Economics, Oxford University, Said Business School). Published in Journal of Investing, December 2020

5. Private Equity’s Diversification Illusion: Economic Comovement and Fair Value Reporting (Kyle Welch, Harvard Business School, 14-January 2014)


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