Private equity at a crossroads

Business Times

2 days ago

LUDOVIC Phalippou, who holds a doctorate in financial economics from Oxford University, has become one of the most closely followed and debated voices in private equity. His articles in Enterprising Investor were among the most-read in 2024, and I was pleased to sit down with him for a wide-ranging conversation.
Known for his sharp analysis and independent perspective, he has long challenged the industry's dominant narratives, and did so with his usual clarity and candour during our conversation.
In our discussion, which aired on May 21 on YouTube, Phalippou revisited several themes that have defined his research: performance reporting, governance, incentives and transparency. But we also explored how the current macro environment and the changing investor base are placing new pressures on an already-complex system. The result is a thought-provoking look at where private equity stands today, and where it may be heading.
* Impact of rising rates
Phalippou began by discussing how the current macroeconomic environment, particularly rising interest rates, were exerting pressure on private equity firms. He said that higher borrowing costs have directly affected the leveraged buyout model that has traditionally underpinned private equity returns. As debt has become more expensive, deals have needed to generate higher operational improvements or revenue growth to offset this financial burden.
Phalippou emphasised that many PE firms were now resorting to financial engineering or restructuring debt to avoid public bankruptcies. But he warned that these tactics might not be sustainable in a persistently high-interest-rate environment.
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* Transparency and governance
One of Phalippou's central critiques has been the lack of transparency in private equity, which he likens to the mutual fund industry of the early 20th century, before reforms were implemented. He has pressed for standardised reporting and stricter governance to protect investors, particularly as private equity becomes more accessible to retail markets.
He has highlighted issues with traditional metrics, such as the internal rate of return (IRR), and delved into how this can be manipulated to present an overly optimistic picture of performance.
* Performance myths
Phalippou has challenged the widely held belief that private equity consistently outperforms public markets, and argued that the metrics used to support this claim often fail to account for survivorship bias or the lack of appropriate benchmarks.
He says that the perception of superior returns is frequently based on selective reporting and marketing rather than reality.
*Alignment of interests
Another key theme in the interview was the alignment – or misalignment – of interests between private equity fund managers, executives and investors. Phalippou stressed the importance of understanding who benefits most from PE structures. He noted that while fund managers often claim their interests are aligned with those of investors, the reality is more complex, and he shared examples.
* ESG practices
When asked about ESG (environmental, social, governance) initiatives in private equity, he offered a nuanced view. While acknowledging that ESG compliance is increasingly important, he suggested that many firms were approaching it more as a marketing tool or regulatory requirement, rather than as a genuine driver of value creation. He cited some ESG initiatives and discussed ESG reporting in private equity.
* Private equity in sports franchises
Phalippou touched on the growing involvement of private equity in owning sports franchises, characterising the trend as a blend of professionalisation and vanity projects. While private equity firms bring operational discipline and financial expertise to sports management, an element of prestige and personal ambition also drives these investments.
* The role of academia
Reflecting on his role as an academic, Phalippou discussed his efforts to demystify private equity for his students and foster critical thinking. He wants them to go beyond the industry's surface-level jargon and be equipped with the tools to ask deeper, more critical questions about the data and assumptions behind private equity practices.
* Challenges facing the industry
Phalippou outlined several challenges that private equity firms are likely to face in the coming years. These include:
Increased scrutiny: As private equity becomes more accessible to retail investors, it will face heightened scrutiny from regulators and the public.
Saturation of the market: The influx of capital into the private equity space has led to higher valuations and reduced opportunities for outsized returns.
Technological disruption: The rise of AI and data analytics has transformed the way due diligence and operational improvements are conducted, potentially disrupting traditional private equity practices.
Phalippou concluded the interview with an analysis of where private equity might be headed. He brought data and deep research to bear on issues that many in the industry still treat as settled. His perspectives on current practices and future direction were clear, direct and thought-provoking – whether you agreed with every conclusion.
The discussion was a valuable opportunity to revisit long-held assumptions and consider how the private equity landscape may evolve in the years ahead.
The writer, a CFA, is a professor of practice at Carey Business School at Johns Hopkins University. He is also the editor of The Journal of Portfolio Management, co-founder and co-editor of The Journal of Financial Data Science, and an editor of Annals of Operations Research.
This content was adapted from an article that first appeared in Enterprising Investor at https://blogs.cfainstitute.org/investor