The Economics of Private Equity with Ludovic Phalippou
"The all-in cost of debt is roughly eleven percent, if not twelve. Let's say eleven. And you apply like a six percent or so of fees on it, you're at seventeen percent. So then you really need a huge growth in earnings. Where does that come from? The basic maths are against you."
— Ludovic Phalippou
Ludovic Phalippou has spent twenty-five years studying one subject, every day, from every angle. Private equity for breakfast, lunch, and dinner, as he puts it. He has read the limited partnership agreements, reconstructed the fee arithmetic, testified before the House of Lords, and built the model behind BlackRock's private-market capital market assumptions.
He is also, by his own account, not especially popular with the industry he studies. What's striking is how little of what he says is actually an attack. He believes private-equity-held companies genuinely are run differently — run for profit, in a way most companies are not, because the people at the top have their own money first in line to be lost. He respects that. The disagreement starts one step later, at the arithmetic: eighteen percent gross, roughly seven percent in fees, eleven percent net. Eleven percent is fine. It is also roughly what US public equities “delivered.”
The conversation holds together on a single discipline: separating what an investment has returned from what it will, and refusing to let the first quietly stand in for the second.
Key Takeaways
1. Private equity's real edge is that the company is run for profit — and most companies aren't.
The naive assumption is that every business maximizes profit. Almost none do. Anyone who has worked somewhere with more than ten employees knows people wake up with all kinds of objectives, and increasing the firm's profit is rarely among them. What private equity does is put the top team's own money first in line to be lost, which makes compensation genuinely symmetrical rather than heads-I-win. The consequence is visible in behavior: a public company hires this consultant for five million dollars to study whether to stock a product, then hires that consultant to confirm it, because nobody wants to own the downside. The private equity owners put it in three stores and watched. That chain is now the UK's largest seller of the thing. It looks stupid because it is simple — and it's simple because nobody's career is on the line instead of their capital.
2. The fee arithmetic is not contested. It is only unspoken.
Roughly seven percent a year, all-in, once you count management fees, carried interest, organizational expenses, and the rest. When that number first appeared in 2008, the response was that its author was “a lunatic.” There's a genuine gray zone at the edges about what counts. There is no gray zone about the order of magnitude. What generates the anger isn't the arithmetic. It's telling people who are treated as gods that the money wasn't possibly quite deserved.
3. The past tense is doing enormous work, and almost nobody uses it.
Track records get described in the present tense — "we deliver" rather than "we have delivered" — and the grammar smuggles in a forecast. Write the model out properly instead. Take the cost of debt where it actually is: about eleven or twelve percent all-in. Add roughly six percent in fees. That's a seventeen percent hurdle before anything reaches the residual claimant. None of this requires a fancy equation: every business has a cost of operating, and the LP gets what's left. There is simply a great deal of costs and expenses ahead of the LP in line.
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About Ludovic Phalippou
Ludovic Phalippou is Professor of Financial Economics at the University of Oxford's Saïd Business School, where he specializes in private equity and private markets — the economics of the asset class as a business, alignment of interests, opacity, and the benchmarking of returns. He has testified before the House of Lords and built the model underlying BlackRock's private-market capital market assumptions. He is the author of Private Equity Laid Bare and, most recently, The Science of Private Market Valuations. He grew up on a farm in France, the first in his family to attend university, and studied at the Toulouse School of Economics before beginning a Ph.D. in economics at USC at twenty-two and completing his doctorate in finance at INSEAD. He began reading private equity limited partnership agreements and fundraising prospectuses when almost no one else in academia had.
Timestamps
00:00 — Introduction
00:35 — From a farm in France to a Ph.D. in the United States
02:00 — Toulouse: forty students, world-class faculty, free
05:00 — Why finance over economics (an honest answer)
06:00 — Reading the first private equity prospectuses in 2001
09:00 — Public versus private equity: what's actually different
10:00 — Run for profit — and why most companies are not
13:00 — Why the consultants get hired: nobody wants to own the downside
14:00 — Leverage: magnifying gains and structuring the downside
16:00 — Eighteen percent gross, seven percent fees, eleven percent net
19:00 — Where the antagonism comes from
20:00 — The three-hundred-basis-point opening and the five-minute conversation
25:00 — Win-win, or heads I win: the alignment question
30:00 — The market for lemons
31:00 — “Have delivered” versus “deliver”
32:00 — What good governance would look like: the ILPA principles nobody follows
35:00 — Why Middle East LPs sue and US pensions don't
36:00 — The next seven years: writing out the math
39:00 — The Pivot Questions
Full Transcript
Jonathan Treussard: Hi, I'm Jonathan Treussard, and welcome to Treussard Talks, where we talk about the mechanics of investing, the psychology of investing, and what it means to manage your wealth with purpose — because understanding your wealth shouldn't be as complex as building it. Welcome to today's show.
Ludovic Phalippou, it's a real pleasure to have you on the show today.
Ludovic Phalippou: Thank you for having me.
Jonathan Treussard: Before we get into the topic of the day — and it's inherently going to be very much about private equity — let me lay the stage on your background. You are a Professor of Financial Economics at the Saïd Business School at Oxford. You specialize in private equity, private markets. A huge focus of your research and your more public body of work is on the economics of private equity as a business: issues of alignment of interests, opacity, benchmarking of returns. Anybody who's ever talked about private equity has talked about things like internal rate of return, IRR. You've done a very deep dive into what all of that means.
And in addition to being a professor, you really have a public policy platform. What I mean by that is you've spoken to the House of Lords in the UK — I think it was about a year ago. You have some version of forty-five thousand people following you on LinkedIn.
But before all of that, you started at the Toulouse School of Economics. As a Frenchman, I happen to know what a great school that is, and it has truly leading people across the field, but certainly when it comes to micro theory and game theory. I'd love to start with your education.
Ludovic Phalippou: I grew up on a farm, the first in my family to even go to high school, and having no money, there was no way I could study far from the farm. I had to be fed every weekend. So Toulouse was the only place, and it was free. And I was always very interested in economics, so I ended up there.
And then, because there are all these crazy people in Toulouse who have PhDs from the best universities in the US and who nonetheless decide to stay in Toulouse for a fraction of the salary they could have in the US — they decided to create a small school within the university, with special students in economics. And it's crazy, because then you would be in a group of forty people with the best professors, and it's all free.
Jonathan Treussard: To be clear, we're talking about the types of people that would otherwise teach at, or were teaching at, places like Harvard.
Ludovic Phalippou: Yeah, yeah.
Jonathan Treussard: Absolutely extraordinary.
Ludovic Phalippou: My industrial organization teacher, who played a big role for me, had a PhD from Caltech. So the guy's a PhD in econ from Caltech, and he's my teacher in IO. And most of my teachers had a PhD from MIT or Harvard, et cetera. It's insane.
I was doing super well. I found it very intuitive. I was very interested. I understood everything very quickly. And so that guy who has a PhD from Caltech said to me, "You know, you should look into doing a PhD in the US."
And I was twenty-one years old, and I was like, "How does that work? I have no money to continue studying. I need to go and get a job at a bank as soon as possible. I'm broke." And he said, "No, but they pay you for it." I said, "They pay you to study?" He said, "Yes, yes, it's free and they pay you." I said, "But how much do they pay?"
And at the time, that scholarship at USC was more than two thousand dollars a month, and basically tax-free. By French standards, this was more than what a professor at a university in France was paid. So I said, "Okay, well, yeah, let's go. I don't speak English, but I'll figure it out."
The reason he was sending me to USC is because there were people from Toulouse going to USC — there were a number of professors who had joint positions between USC and Toulouse. And because I didn't speak English, I knew nothing about anything, and I was so young, they said, "Look, you have to go there. You have these Toulouse guys who are going to take care of you, otherwise you're going to drown in the US."
And so this is how I was technically one of the youngest PhD students in economics in the US — twenty-two years old, at USC. And I did well. But I didn't feel like staying in economics and doing industrial organization, which is what these guys were doing, and staying in LA. So then I asked whether I could transfer to INSEAD — and if they had said no, I would have continued at USC.
Jonathan Treussard: Sure.
Ludovic Phalippou: They were okay with that. So I transferred to INSEAD, and this is how I ended up with a PhD in finance at INSEAD.
Jonathan Treussard: That's a fabulous story. And obviously I want to hear more about your time at INSEAD, which allowed you to focus on the finance side of things — and it happens to be in the beautiful woods outside of Paris, at least that's where the home base is. Kind of suspended outside of normal society, so you could really focus on your studies in a lot of ways.
But I love your story in so many ways, and of course I love it because it feels so personal. I have a very comparable background. I moved to the US when I was seventeen years old. I stumbled into school. I happened to, as you said, be pretty darn good at it and intuitive — but that was to be discovered.
After getting my undergrad at UCLA, I guess I was twenty-two, actually. So I don't know about your claim about being one of the youngest PhD students, my friend. A friend certainly made history for me when he said, "You should apply to BU. They're a private school. Surely they have money." And I ended up getting a full Presidential Fellowship to get my doctorate at BU, which totally changed my life.
But somewhere along the way, you went from the micro stuff we were talking about — industrial organization and all of that — to wanting to focus on the adjacent field of finance, as opposed to the main field of economics. So what motivated that?
Ludovic Phalippou: I was intrigued by finance. I was intrigued by stocks and all these things. But also, there is a pay gap in academia. Professors of finance are much more paid than the ones in econ. So I thought, the question is super interesting, and if I get paid twice as much, why would I do the econ track? This was a very simple motivating factor, I would say. I must confess.
Jonathan Treussard: I love that.
Ludovic Phalippou: One.
Jonathan Treussard: No, but it's an honest one. And again, I say to people, "Look, I left Los Angeles somewhat reluctantly, but it was the first economically motivated decision I made." I think economically motivated decisions are, I guess, refreshing. They're like the textbook said, right?
So you're at INSEAD, you're finishing your doctorate. At that point you've made the full switch. You're doing finance research?
Ludovic Phalippou: Yeah, it's a hundred percent finance. And I have three different papers, but one of them is on private equity already. Because I came across this classmate of mine who basically told me, "There is this thing called private equity, and I have all this data." And so this guy had limited partnership agreements. He had fundraising prospectuses, all these PPMs and so on.
In 2001, nobody had seen that. Nobody had put that together. And so I started reading these things extremely early. I was reading these fundraising prospectuses and the like. At the time, it was very common to study mutual funds and all the conflicts of interest in the mutual fund industry, and in the finance industry in general. And so I was very much influenced by these things.
So when I was reading these prospectuses from private equity, I was like, "Oh, these guys from mutual funds — you're making a big deal of it, but they are angels. Okay? This late trading or whatever, this is peanuts. Look at that." And so very early on, I was struck by what I was reading. I was like, "You've got to be kidding me. There's no way."
Especially in contrast with these mutual funds. Around 2000, there were all these fines that were distributed to mutual funds. Academics were doing a lot of research on mutual funds and uncovering all kinds of bad behavior, and the mutual funds were getting caught by the SEC. And at the same time, I was reading all these things in private equity. I said, "This is magnitude ten."
Jonathan Treussard: This is the big league.
Ludovic Phalippou: And these are the real ones. I also had Steve Kaplan, who was visiting INSEAD and gave a course in private equity, which I attended. We had a fight as soon as the first hour of the course. He was showing his research in private equity, explaining what leveraged buyouts were, et cetera. And I felt like, "You've got to be kidding me. It cannot happen this way."
And so all of this combined meant that I did have a paper in private equity, but there was no literature really at the time. It's not easy to publish, or to go on the job market, with something that no one else is doing. So I went with a more standard paper on the value premium and didn't go very far with it. People kept on paying lots of attention to my private equity work, because there was so little of it out there. Not so much the academics, but the rest of the world was paying attention to these things.
And so this is how the rest of my research agenda shrank, and private equity became my life. I have it for breakfast, lunch, and dinner, every single day, for the last twenty-five years. It's all I do. I talk to journalists about it, they tell me about it. I teach it, and my students tell me about it. The practitioners I bring to calls tell me about it. I talk to policymakers and the like about it, they give me some feedback. I present it in my research, I get feedback from my peers. So it's huge, and I do that every day.
Jonathan Treussard: Let's ground ourselves in a couple of things. One is, I think it'd be helpful — and private equity, perhaps the reason why it's more of the Wild West, is there is an aura that somehow it's special, somehow it's different. So first off, ground us in the comparison, the compare and contrast between public equity investing and private equity investing.
Ludovic Phalippou: In my first hour of lessons on private equity twenty-five years ago, when Steve Kaplan said, "You know, these companies are run differently," I was skeptical about it. The story that somehow, because you're in private equity, the CEO is going to be smarter than if you're a publicly traded company CEO — I had difficulties getting that argument.
Twenty-five years on, I fully buy it. I've had examples after examples that private equity companies are really run differently from non-private-equity-held companies. I have basically zero doubt about that.
Jonathan Treussard: So tell me what you mean by that.
Ludovic Phalippou: They're run for profit. And what we tend to naively assume is that any company is run for profit — and they are not. Companies have all kinds of objectives. Anybody who has worked in an organization, even with ten employees or more, knows that people have all kinds of objectives, and no one is waking up in the morning saying, "How do I increase the profit of this company?" Or maybe some of the employees, but not many. So most companies are not run for profit.
Private equity: the top ten guys put a lot of their personal money in the company. It's their money. If it doesn't fly, they lose their money, and they are the first ones to lose it. So if the company doesn't hit a milestone, the first people to lose money are the CEOs, CFOs, et cetera. That aspect I really like about private equity, and I respect that. In Europe, it still is the old model, where people would really put their money into it, and the first one to lose is the head of the company. So if we are missing a milestone, he's the first guy to lose his shirt.
And so if it works well, they earn disproportionately compared to anyone else — which, fair enough. Often when some CEOs of big publicly traded companies make like ten million a year and say, "Ah, it's because my profits went up, I'm so good," I'm skeptical of that claim. There's a lot of luck. So you may be good, but there's a lot of luck. And I'm fine with luck — but not if you don't have your own money on the table, and heads you win and tails you just didn't win. That's very much how publicly traded company CEOs are paid. If I'm lucky, oil price goes up, I have an oil company, I'm going to get a massive stock option payout. Oil price goes down, then I don't.
Private equity — you may have that luck, that you are running a company in private equity, oil price goes up, your profit increases, you will make a huge amount of money. But it was your money on the table. If it hadn't worked, you would have lost your money. You put your money where your mouth was.
Jonathan Treussard: It's more symmetrical, I guess, is what you're saying.
Ludovic Phalippou: It's much more symmetrical for the management of a company, for sure. It's actually very symmetrical. In the US, you still have quite a lot of stock options and things. It's not as symmetrical as it is in Europe, but the spirit is there.
If you take Hilton Hotels — the LBO of Hilton by Blackstone — the management team walked out with about eight hundred million dollars in compensation. So pause on that. Eight hundred million dollars of compensation earned. You don't have any CEOs that got eight hundred million in compensation. So that's the C-suite together: eight hundred million. If Hilton had gone under, they would have lost some of their personal money. They had to put some of their personal money on the table, and a non-negligible amount. So I respect that.
And what that does is that it changes everything. So they are run for profit. And when you pay people based on one metric, that metric goes up. If I pay people on the number of kilometers they run, people will start running many more kilometers. Because they will start focusing on that, and anybody would just increase dramatically the number of kilometers they run. If you pay people on profit, profit will go up.
I've had lots of CEOs coming to class and giving very concrete examples of what that means in practice. You would have this company in the UK where they hesitated about putting a product in their stores. And therefore they were hiring McKinsey to make a study of whether they should sell these things in the store. And then McKinsey would say — for five million dollars a report — that it may or may not work.
Jonathan Treussard: Here are the pros, here are the cons.
Ludovic Phalippou: And then they would hire BCG, and BCG would come to the same, and so on and so forth. So they had spent millions on consultants. Why did they hire all these consultants? Because nobody wanted to take the blame. Nobody wanted to be the guy who would have introduced it. If it had worked, you get a tap on the shoulder: "Well done, proud of you." And if it doesn't work, you're a loser, and you will never be promoted. And so then people hide themselves behind, "Okay, here are consultant reports, and we'll see what the consultants say."
Private equity guys come in. They take three stores, they put the product in the three stores, and look if people pick them up. And people did. And today that store chain is the largest seller of that product in the UK. So it looks simple and stupid, but if you work in any big company, that's how it works. People are just doing all kinds of weird things that are not profit-enhancing for the business.
Jonathan Treussard: Yeah, they're managing their career.
Ludovic Phalippou: Exactly. The other thing that is special, and you mentioned it, is the leverage. You're working in an environment where the capital structure of a company is upside down. That's why, in my book, I wrote "Alice in Wonderland" — because everything is upside down. So you have more debt than equity.
That does quite a few things. On the one hand, if you increase leverage on a company, you will be riskier, you'll be more fragile. On the other hand, this debt is very cleverly structured, with lots of credit lines and buffers and flexibility, which means that you manage to operate with very large amounts of debt.
You will lose sometimes — about ten percent of the deals will lose the full equity. But it's not massive. If you think about it, when you have such a level of leverage, you'd think that across business cycles you would have fifty percent losses. It's much less than that. So you have a lot of leverage with a very convoluted, very complicated structure, but which brings a lot of flexibility.
What this leverage does is that it magnifies your gains. So you increase the profit of a company, it's massively levered, your gains get multiplied. So even though the leverage is very expensive, you manage to decouple this economic profit. The economic profits are not huge, but they are there. Then you multiply them by leverage, so they become sizable.
So then the question becomes — we have the numbers, we know, in the past, in the low interest rate environment. The 2000s and 2010s are different from nowadays. We know the numbers. The average LBO, gross of fees, would generate about eighteen percent returns. It's enormous. It's a Warren Buffett track record, on average, for the average guy.
So the fees that private equity charges — I've done different simulations. We don't have a number. Nobody has calculated it. Nobody has kept all the data. It's probably in the ballpark of seven percent a year, which is never heard of in any financial product in the Western world.
Jonathan Treussard: It's nice work if you can get it.
Ludovic Phalippou: Yeah. And you can check the list of billionaires on the Forbes list. You will see all these private equity guys. You can look into any neighborhood where the most expensive houses are, and see what their job is. And you'll see the private equity guys in about any city in the world.
I was in Amsterdam this weekend. You go to the most expensive areas of the Netherlands. Some of these houses, I was told, "Oh, this is the founder of this private equity firm." I say, "Which firm?" And they give me a firm I've never heard of. It's not even a big private equity firm, but the guy had the biggest house in the country. And it's the same in LA and everywhere, I'm sure. You have the actors that would take a few shares. But outside of that, you'd have some sports guys and the private equity guys.
Net of fees is like eleven percent, which is not bad, but it's about what the average public equity returns in the US have been. So that's basically the picture.
Jonathan Treussard: So as you said, you've got the very real part, which is a hyperfocus on a single variable, profits — which in a weird way, again, people walk around assuming is what goes on in the public world. But the truth is it rarely does, and it certainly doesn't in the depth of the organization. Maybe the CEO is focused on it, if we're lucky, though maybe the CEO likes being on TV just as much. But then very quickly you go down the ranks, and the SVP of schmuckity-schmuck really is worried about the person across the hallway that has a marginally bigger office than they do, and has completely lost focus of what this thing is about. I totally get that.
And to your point about the intersection of leverage and structuring — the way I think about it as an economist is, that's all the internal stuff. That's all the stuff you control. But then there's all the stuff you don't control: the world, the business cycles, all of that. And what you're saying is, well, obviously they're exposed to the same vector of shocks to the upside and the downside, but at least the equity bit is somewhat buffered by clever structuring on the leverage side of things. Which totally makes sense.
And you're right, quote unquote, the fees are yacht-worthy, if you will. They'll buy you big houses. But along the way, I guess nothing you've said so far certainly feels controversial. It just seems like a reasonable, painful statement of the obvious. And yet you've acquired this persona of — I don't know if you would describe yourself as such, but certainly the caricature becomes, "Man, this guy really hates private equity." In fact, I think you've told students, "If you're interviewing for a PE job, don't mention my name."
Ludovic Phalippou: Here.
Jonathan Treussard: So where does that come from? Because I know you've talked about IRR and the implications of that, and the fact that anybody who's ever taken a course in corporate finance knows that IRR is kind of a weird internal fiction. It's not a real number that anybody eats. But tell me, is that part of it — the numbers that are put out to sell the story? What is it that creates that perceived antagonism, I guess I'll say?
Ludovic Phalippou: Everything I've ever written can be double-checked. There is nothing proprietary. It's very easy to check everything I've written. Nothing has ever been proven incorrect. But even what I just said — they go bananas on it.
People are very sensitive to this idea that you've got a lot of money and you didn't quite deserve it. They go bananas. They have very big egos. Even the first time I came up with a fee at seven percent a year was in 2008. People said I was crazy. They said, "There's this lunatic at INSEAD. He came up with fees at six percent minimum, like, the average fund. This guy is nuts. He has something against us. He doesn't make any sense."
Jonathan Treussard: I guess the expression would be, you were saying the quiet part out loud. It's like, "We don't talk about this."
Ludovic Phalippou: Yeah. And it would be like, "But why, why do you care? The soup is good. We give good returns to our investors. Why would you want to know how much we make? What's your problem?"
So it would be to a point where even when I — this first paper quantifying fees just added organizational expenses, management fees, and carried interest. Even on that, they would say, "Organizational expense is not a fee. Carried interest is not a fee, it's a profit-sharing agreement. And so management fee is a fee. But even your assumption that it's two percent on capital committed for five years and so on, it's not even true. We don't even charge that."
So even that simple thing, people push back. You could go to any sales guy in private equity, even an aggressive one, and show my back-of-the-envelope calculation. First, he will deny it. First, he will say, "No, no, it's three hundred basis points." Then I just need five minutes with the guy, and then he will work it out and say, "Yeah, that's fine. Okay. Yes, it's six, seven percent." And then other people that are seen as more politically friendly among academics cite six, seven percent, or come up with the same number. So there is consensus.
The sales guy is not going to tell you that number right away. You'll have to show that you know what you're doing, and then they will confess. Then they will tell you, "Okay, that's fine. Yeah, okay, carried interest is kind of a fee. Fine. And yeah, on the management fee, we don't charge quite as much, but it's because we take portfolio company fees, but we refund against the management fee. So yeah, we didn't charge that much" — but in fact, they did.
And then you can say, "And then there's fund expenses and this and that." And they say, "Yeah, but fund expenses are not really a fee. These companies would have had to pay it anyway." So then there can be a gray zone where we can debate what is a fee and what isn't. But at least the first seven percent — there is no debate.
Jonathan Treussard: The order of magnitude is kind of accepted.
Ludovic Phalippou: For the part that is acceptable as a fee, it's seven percent. But again, a salesperson would never tell you that. Never. They will always say it is about three hundred basis points. Even that is very controversial.
And if you say, "And the net performance is eleven percent" — again, you go on the MSCI Burgiss interface, you go to Preqin data. Anybody can buy them. You check what is, on aggregate, if I had invested in all the private capital funds in the world, how much would I have made? And the answer is eleven percent. You go on the CalPERS website and say, "How much did CalPERS make since inception?" Ten point six percent. And CalPERS is not a loser there. It's at the average.
But if you cite that, people start getting very upset. And then usually their counterpoint is, "Well, but this is much better than public equity." And then they will bring a crappy benchmark they found somewhere, like MSCI World or Russell 2000, and say, "This is better than these two benchmarks."
And so the core of the anger is to tell someone who's super wealthy, who thinks that therefore they are super smart and geniuses and clever — for sure the average guy is pretty clever in that industry — but they are convinced that they are gods, basically. And they are treated as gods. Once you have that kind of money, you are treated like a god on a daily basis. If you explain to someone, "You know, this money is not really deserved" — you focused the management a bit more on profit, and you levered up to hell in order to get money that you took out all in fees anyway. And then your limited partners just got what they would have gotten otherwise.
Jonathan Treussard: Yeah, they'd have done perfectly fine. And again, I think that's the thing that's so interesting to me. Maybe it's our training or whatever, but it's just like, "Hey, we're not accusing you of something awful," quote unquote. You're just saying, "Hey, you were part of this weird wrinkle of moving the capitalistic machine down the line, and you did it in a competent manner. You certainly took a good chunk of what the economic machine was spitting out, and you delivered pretty solid equity-like returns to your investors."
To me, that would be like, "Cool, I guess I did okay." You know what I mean? That doesn't feel awful.
Ludovic Phalippou: Yeah. So the thing is that they don't stop there usually. But already there, they're very upset. Okay? So already they're very upset. But where I have a personal touch is that I also insist on two things.
[Thanks for listening. I'm Jonathan Treussard, founder of Treussard Capital Management. I hope you're enjoying this episode. If you'd like to start receiving my free newsletter, Wealth, Empowered, or if you'd like to learn more about me and Treussard Capital Management, go to treussard.com. That's T-R-E-U-S-S-A-R-D dot com. Thanks, and enjoy the rest of the episode.]
Ludovic Phalippou: The first one is that the future can be very different from the past. So in a high interest rate environment, high valuation environment, if you do not modify your fee structure, you are going to deliver low returns and have charged a lot of fees.
Jonathan Treussard: That's mechanical.
Ludovic Phalippou: If things went well and you made a lot in fees and you gave okay returns — fine, maybe we forgive you. But your fee structure is such that heads you win, tails I lose. And that's where I bring that on the table and they start getting very upset. Because that's a bit more confrontational — this idea that we are partners with our clients, it's a win-win, our interests are aligned. They are not.
Jonathan Treussard: And just to clarify the mechanics: forget the private equity thing for a minute, because we're talking about leverage and therefore borrowing, and so the rates stack in the wrong direction. But think about it as the long side of investing. If you're earning, it becomes the opposite picture, but it's a clear picture. When interest rates are zero and you're charging any fees on top of it, it's pretty straightforward — you're upside down very quickly. But of course, when interest rates are five percent, you can take a pretty decent cut and still leave money on the table for your investors.
The problem is when, instead of being on the long side, you're talking about borrowing and therefore paying those fees. It all adds up. Whatever the economic return is, then you have to pay the seven percent to the PE guys. You've got to pay the five, six, seven percent funding rates. Maybe it's even higher. Maybe it's twelve percent funding rates. And all of a sudden you're like, "Holy smokes" — there isn't a lot left.
Ludovic Phalippou: It's not easy to prove, but it doesn't add up. We know they are in trouble at the moment. It's obvious. So they start getting edgy if you bring this up.
Then I've shown in many instances that the interests are not aligned. They do a lot of things that are not nice to their LPs. A number of them — not all of them, but a number of them — put themselves in very conflicted situations, when they start charging the underlying assets all kinds of fees and charges that go to themselves. And they're in control of a company with someone else's money, and they get cash out of these companies to themselves. This is tunneling, like you would see in South Korea, or in India even just twenty years ago — not even nowadays.
Of course, they don't like that. But I emphasize it, and again, it's factual. I put contracts on my website. There are a few hundred contracts. You can read them. You can see how they extract, and so on. It went to the SEC, and it was a big deal. And then now they say, "Oh, but now we don't do it anymore, so we are good." I say, "Yeah, but you did it for twenty years. You cannot just get away like this." First telling me I'm an idiot, and I'm anti-private-equity whatever. And then once all the proof is on the table — and it took me five years to put it together — then you say, "Oh, that's fine. Okay, we stopped doing it. It's behind us now." What are you talking about?
So that they don't like. And then I forgot the third one. But there are a few things that I say that they don't like.
Yeah — the IRR. The other thing that they don't like is that I insist on the fact that their prospectuses, the way they sell the asset class, is extremely misleading. Anybody doing half of that in a mutual fund would go to jail. And so these guys are allowed to do all kinds of very surprising things when it comes to presenting their track records. And they don't lie, because they would go to jail for lying. There are lots of things you can do without lying, which gives you amazing power to paint extremely rosy track records.
So I've insisted a lot on that because, as you said, if they had given the true picture — the balanced one that I started with — I'm good. If some people are willing to pay for that, it's fine. I'm in. Even if some people say, "Okay, I understand that on the downside it will work differently, but I signed the contract," I'm all good. I'm fine. I have nothing to say about that.
But if you are doing misleading marketing material, if you're doing misleading narratives and presentations — and again, you are competing with people in mutual funds and other financial professionals that would go to jail for half of what you're saying — I don't think it's fair.
Now, of course, then they hate me. But all the guys in mutual funds love me, because they're like, "Yeah, I'm very annoyed with these guys for eating my lunch every day by bullshitting." So certainly I do have a core group of people that I'm annoying very much, but there are a number of people that are saying, "Yes, this is helpful."
And even within private equity, some people recognize that if you reward the people who are more truth-telling, you reward the best guys. Enabling people to hide bad track records only protects losers. So you also have a few people in private equity that say, "Yeah, I love what you say, the message and what you do."
Jonathan Treussard: That's the market for lemons right there.
Ludovic Phalippou: Yeah. Yeah.
Jonathan Treussard: I mean, I think that's right. And so obviously you're going to have the people that feel like they're being unfairly competed with, versus the people that may be unfairly competing.
But to me — and I'm in wealth management, so I get to look at this from the outside looking in, with the benefit of a PhD in economics and years of experience at family offices and so on — to me, it's just a statement of what is. And by the way, I feel the same way about the past versus the future. One of the things that does drive me bananas is when people describe track records using the present tense.
Ludovic Phalippou: Deliver.
Jonathan Treussard: Yeah. I'm like, "No, you have delivered it. That's so great. I'm really happy for you. I don't know what the future is."
But the point is, you can say, "Hey, public markets have delivered blah under a certain set of circumstances," starting conditions, things like valuations, whatever. Then you can say, "Private markets, including private equity, private credit, whatever, have delivered whatever." And the numbers are what they are, the risk characteristics are what they are, the correlations, you name it. And you say, "Cool, that's great." And then you say, "But what about..." At this point, this is just a statement of the past.
Okay, so I want to focus on this. I guess there are two questions. One is, if you got to wave a wand — and I guess you've tried, you've talked to public policy leaders — what does good governance look like? And then my second question becomes: what do you think the next seven years looks like in private equity returns, now that interest rates don't seem to be budging down? What does the economics to the LP look like on a prospective basis?
Ludovic Phalippou: So the first one was what good governance looks like. Basically, if you come across — and there are some private equity firms that will tell you, "We don't charge portfolio companies any fees, unless it's a co-investment and we have to, and then we refund everything." And if it's very clear what all the expenses are that are taken care of by the GP versus what is put on the fund, if somebody's clear about all of that and clean, and also in the way they define their management fees and other fees.
You can take the ILPA principles. You go to the ILPA website. Nowadays, the Association of Limited Partners — they have a list of what they think a proper limited partnership agreement would look like. It's called principles. Well, then that would be good.
And what people may not know is that so there is an industry association with principles, and the fraction of funds that would be coherent with these principles, or would follow these principles, is close to zero. So it's quite amazing. It's a very big industry. Some people have bothered to write principles on a website, to consult with a lot of people and say, "These are the minimal things it would be good to have."
Jonathan Treussard: But there's still — I guess maybe that's not quite true right now, because I don't think there's a huge amount of money necessarily flowing into private equity, certainly not the way it did a few years ago. But I guess the point is, it's almost like a union that says, "Hey, these are our union demands." But in the meantime, the demands are not met — but take our money.
Ludovic Phalippou: Yeah. But I've explained also that the core problem is the argument that these are consenting adults, so it must be that the contract is right. And so there was even a US senator at a hearing in the US Senate who just said, "I don't understand what you're about. These are consenting adults. Nobody's forcing the LPs to invest in private equity, so you must be wrong. Just leave us alone. Don't touch these guys. Let them do their life."
Nobody forced any investor into Madoff. So this argument is very weak. I don't know which type of investment people really get into at knifepoint. I've never seen that — not even for Madoff. They were very willing to invest in Madoff. In fact, they were fighting to do it. This is a very weak argument.
The other thing that people are missing is that if I'm the head of private equity of CalPERS, I'm not going to trash private equity.
Jonathan Treussard: That's your whole job.
Ludovic Phalippou: Money has to be allocated to private equity. So I'm not going to start whining that the contracts have weird clauses and things that are dangerous, that the expected returns are not very good, and so on. Because the next thing that's going to happen is that less money will be invested in private equity. I will lose some people in my team. And going back to things not being run for profit, I would just want to have the biggest team possible.
Jonathan Treussard: Empire building is a huge thing.
Ludovic Phalippou: The ultimate person whose money it is, is far away. An example I give nowadays is that now that the Middle East has become increasingly educated about private equity, the contracts and all these things — and in the Middle East, it's really their money that is on the table when they invest in private equity, even if it's a large organization — we see a few lawsuits. There are a few lawsuits going on where Middle East investors are suing US GPs. And these guys are like, "Us being sued by LPs? What is that?"
Jonathan Treussard: This has never happened.
Ludovic Phalippou: A pension fund in the US would never sue a GP. It's impossible. So when it's people's money, and people are in a capacity to understand, they behave differently. Some examples of that with the Middle East LPs at the moment.
So that's what good governance would look like. And then your second point was?
Jonathan Treussard: Well, people like to point to the past as a track record that can be extrapolated forward. What do you think a reasonable point estimate is at this point?
Ludovic Phalippou: So for full disclosure, I'm the one who did the CMA for BlackRock for private markets. So if you go to the BlackRock CMA webpage, which is the second most visited after the ETF page, this comes from a model —
Jonathan Treussard: And CMA is capital markets —
Ludovic Phalippou: Assumptions. It's where you can find the expected returns of different asset classes, volatility, and the like. So all the private market ones are from a model of mine. I published this model in a book I just released, called The Science of Private Market Valuations.
It's a formula. You can write an LBO model. You know the cost of debt at the moment. You can take a range of expected growth of earnings of companies, and you can play around with your low estimate, your high estimate. Multiple expansions or contractions — you could say maybe there'll be an expansion of multiples. Many people are skeptical about that, especially with higher interest rates. So what if the multiples don't move, which is already quite optimistic? What if they decrease a little bit? What is then the expected return, given the fee structure and so on?
It's negative. You need to be super aggressive to manage to write an LBO model that has a positive return in this environment.
Jonathan Treussard: Yeah, you're fighting a tsunami. You're fighting a tsunami of funding cost, valuations, and fees, is kind of basically the...
Ludovic Phalippou: The all-in cost of debt is roughly eleven percent, if not twelve. Let's say eleven. And you apply like a six percent or so of fees on it, you're at seventeen percent. How do you...
Jonathan Treussard: No, that doesn't seem like —
Ludovic Phalippou: Right?
Jonathan Treussard: It's one hell of a bogey.
Ludovic Phalippou: So then you really need a huge growth in earnings. Where does that come from? Maybe you have a niche, and in that niche it's fine. You can buy low, sell high, and increase earnings, maybe. But the basic maths are against you.
Jonathan Treussard: Yeah. Isn't that so interesting? After all of this, the punchline really comes down to: you really don't need a fancy equation. It's, hey, everything's a business. There's a cost of running this business, and then whatever's left over is going to, quote unquote, the residual claimant. The residual claimant, of course, being the LP in this case. And you're like, man oh man, that's just a lot of expenses before anything flows to the LP.
Ludovic Phalippou: But I'm very excited about my fancy equation in chapter eight. Have a look. I derived in closed form the expected return on an LBO.
Jonathan Treussard: I cannot wait to check it out. Remind me the name of the book, if anybody wants to go check it out.
Ludovic Phalippou: The Science of Private Market Valuations. I have only two books on Amazon anyway — this one and Private Equity Laid Bare, which I would equally recommend. And I was just before this call playing with the Google thing. I didn't know Google was getting very big in books and audiobooks, but I'm going to also post it on Google, so you can read the book through their apps.
Jonathan Treussard: That's really cool. That's really, really cool.
Well, this has been a really fabulous conversation. And again, it's nice to actually apply logic to things, as opposed to marketing and magic. And if you're not emotionally tied into the conversation, it just kind of makes sense, doesn't it?
Ludovic Phalippou: I think so. There's the expression — it's very hard to make someone believe something that his pay goes against. You cannot convince someone if...
Jonathan Treussard: Well, obviously Charlie Munger famously said, "Show me the incentive, I'll show you the outcome."
Ludovic Phalippou: That one is a good one.
Jonathan Treussard: Someone I deeply respect recently gave me another version of this, which is a little more poetic. He said, "He whose bread you eat, their song you will sing." Which I guess makes you a bird. It really resonated with me.
Well, you grew up, like myself, in France, so maybe — this is kind of exciting for me. I've never done this with a French person. But at the end of every episode, I ask my guests the same set of questions, and this is a set of questions I inherited from Bouillon de Culture with Bernard Pivot. So this takes us back to the old days, my friend, when we were young and only had a couple of channels on TV. I've got ten questions on the way out. You can answer them as literally or as metaphysically as you need to. Do you feel ready?
Ludovic Phalippou: Okay, I'm nervous.
Jonathan Treussard: Okay. What is your favorite word?
Ludovic Phalippou: Love.
Jonathan Treussard: What is your least favorite word?
Ludovic Phalippou: Hate.
Jonathan Treussard: What is your favorite drug?
Ludovic Phalippou: Cycling.
Jonathan Treussard: I saw that picture of you on social media. What sound or noise do you love?
Ludovic Phalippou: Birds.
Jonathan Treussard: What sound or noise do you hate?
Ludovic Phalippou: City noise, or screams. Sirens. Police sirens. This is bad.
Jonathan Treussard: What is your favorite curse word?
Ludovic Phalippou: I will reveal where I'm from, but it would be macarel.
Jonathan Treussard: Macarel. Okay. Who would you like to see on a new banknote?
Ludovic Phalippou: Barack Obama.
Jonathan Treussard: What profession, other than your own, would you never want to attempt?
Ludovic Phalippou: Being a cyclist. A professional.
Jonathan Treussard: If you were reincarnated as a plant or an animal, what would it be?
Ludovic Phalippou: Oak tree.
Jonathan Treussard: Oak tree. Okay, that seems peaceful. Are you ready for the last one? If Heaven exists, what would you like to hear God say when you get to the pearly gates?
Ludovic Phalippou: "You did your best, and you brought a lot more good than harm."
Jonathan Treussard: I think you did that today. Ludovic Phalippou, thank you so much for your time.
Dolores: This podcast is for entertainment and education only. Nothing here is financial advice. Treussard Capital Management is a registered investment advisor. Please visit our website, treussard.com, for additional information and disclaimers.
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The content of "Treussard Talks" is for informational and educational purposes only and should not be considered financial advice. The views expressed are those of the host and guests and do not necessarily reflect the opinions of Treussard Capital Management or its affiliates. Consult your own financial advisor before making any investment decisions. For full disclosures, visit treussard.com.