This August, President Trump signed an executive order
allowing private equity firms to tap into America's 4O1K system.
The stated goal was to democratize access, to stop
babying smaller investors, and to let them play in the same
sandbox as pension funds and sovereign wealth fund managers.
Nothing says democratization like handing your retirement
savings to Apollo. So why are the shares of
publicly listed private equity firms underperforming the
broader stock market so badly this year?
You'd expect a rally instead. The GLPE index is down nearly
10% year to date, and it's even down slightly since the
announcement in early August. Apollo and Blue Owl are off more
than 20% year to date. KKR, Aries, and TPG are all in
double digit decline. Blackstone is down too, with
Carlisle and Three I being outliers up more than the S&P.
It turns out that letting retail investors into the sandbox
doesn't necessarily help if the sandbox is full of broken toys.
The Wall Street Journal points out that some of the
underperformance might reflect an overhang from the run up in
stock prices over the last few years, especially for some of
the big firms who rallied ahead of being included in the S&P
500. But there's still concerns
hanging over the industry. Private equity firms are
struggling to sell prior investments at attractive
prices, and without exits, there are no distributions.
Without distributions, it's much harder to raise new capital.
Private equity is still sitting on trillions in assets, but the
flywheel, raise, deploy, exit, distribute and repeat isn't
spinning the way it used to. And the push into four O 1 KS
looks maybe less like innovation and more like a search for new
investors when the existing ones are getting frustrated.
The S&P 500 is up around 14% this year if we include
dividends. But it hasn't been a broad based
rally. The returns have been
concentrated in a handful of tech giants, the Magnificent 7
minus Tesla, plus Broadcom, which make up more than 1/3 of
the index. These firms are growing
earnings, throwing off cash and doing it with less leverage than
their predecessors. In the.com era, investors have
been paying up for profitability and the market has been
rewarding them. Private equity doesn't own any
of these companies, and it doesn't own anything like them
either. PE firms tend to own smaller
businesses, often in slower growing sectors and usually with
a lot more debt. The typical buyout fund is a
leveraged bet on small cap value stocks, the exact corner of the
market that's been lagging. It's not unreasonable to expect
private equity returns to rise and fall with the broader stock
market, adjusted for the additional leverage.
But that relationship breaks down when the market is being
driven by a narrow set of mega cap tech stocks that private
equity funds have no exposure to.
The IPO market has been dead for quite a while, and the kinds of
companies sitting in private equity portfolios simply aren't
what public investors are looking to invest in.
Investors are not interested in paying top dollar for slow
growth businesses with heavy debt loads, and that's making it
much harder for PE firms to exit cleanly.
Benchmarking private equity against the S&P 500 has always
been a bit of a stretch. The sector invests mostly in
U.S. companies, but they're smaller, more cyclical, and more
heavily levered. A better comparison might be a
basket of small cap value stocks with a few turns of debt layered
on top, but even that's generous.
Most small cap value ETFs don't charge fees of 2 and 20.
Private equity is often described as being an asset
class, but it's really just a structure.
Most of the capital is deployed through buyout funds, which
acquire controlling stakes in private companies using a mix of
equity and debt, the debt does most of the heavy lifting.
A typical deal might be financed with 60 to 75% leverage, far
more than you'd find in a publicly listed company where
debt to equity ratios tend to hover around 30%.
The idea behind private equity is simple.
Borrow heavily, buy a business, improve it or at least manage it
somewhat efficiently, and then try to sell it later for more
than you paid. The returns are supposed to come
from operational improvements, multiple expansion, and most
reliably leverage. The people picking the companies
to buy often have backgrounds in investment banking or
consulting. Whether that qualifies them to
run a plumbing supply company, and whether they can run it
better than its founder did is a separate question.
But hey, if you can model A leveraged buyout in Excel, how
hard can toilets be? Private equity funds tend to
concentrate their bets in smaller companies, often in
mature industries. The reason being that steady, if
boring business models are much easier to borrow against.
No one wants to lend money to a business with negative or even
highly variable cash flows. That gives them exposure to the
small cap and value factors tracked by academic finance.
Historically, these factors outperformed, but that hasn't
happened for quite some time now.
PE funds also claim to offer access to the illiquidity
premium. The idea is that buying hard to
sell assets at a discount and locking up investor capital for
years should result in higher long term returns.
Whether that premium exists or not is debatable.
What's clear is that the fees are high, the leverage is
substantial and the exit routes are narrow.
Private equity firms like to tell a story.
It's it's a story about transformation, of taking
sleepy, underperforming companies and turning them into
lean, efficient, high growth machines.
The protagonists are former investment bankers and
consultants who, armed with spreadsheets and strategic
vision, unlock hidden value through operational excellence.
This is the myth of operational alpha, but the numbers tell a
somewhat different story. Most of the returns in private
equity come not from operational improvements, but from leverage.
A typical buyout is financed with 60 to 75% debt,
significantly more than the average for public companies.
That leverage amplifies returns when things go well, but it also
introduces fragility. But that part of the story is
usually left out of the pitch deck.
The idea that private equity managers are uniquely skilled at
running businesses is hard to square with the resumes of many
of the general partners. These are usually people with
backgrounds in M&A, not manufacturing.
They know how to structure a deal, but next to nothing about
how to run a plumbing supply company.
The founder that they're replacing, usually with a junior
banker, may have spent 30 years building the business in
question. The new owners have a five year
exit horizon, the ability to borrow huge sums of money, and a
model that assumes margin expansion.
You might be surprised to hear that margin expansion rarely
materializes. Bain's 2025 Global Private
Equity Report shows that in the software business that they buy
out, margin growth has contributed just 6% to value
creation over the last decade. The rest of the return came from
revenue growth and multiple expansion in carve outs
transactions. Where a private equity firm
acquires a non core division or subsidiary from a larger
corporation, the story is similar.
Pre 2012, sponsors boosted margins by 29%.
Since then, that figure has fallen to 2%.
Even when operational improvements are real, they're
often overstated. As the CFA Institute and others
have pointed out, the industry's preferred performance metric
since inception, IRR, is highly sensitive to the timing of cash
flows and can be gained through subscription lines and bridge
loans. It's not a rate of return in any
meaningful sense. It's a marketing number or the
financial equivalent of Instagram filters.
Flattering, but of nothing like reality.
Warren Buffett has long criticized the private equity
model for this reason. At Berkshire Hathaway's 2019
meeting, he noted that investors in PE funds must hold cash on
the sidelines ready to be called.
That cash earns very little, especially during the 0 interest
rate environment of the time, but that doesn't show up in the
IRR. The result is a flattering
returns number that ignores the real world cost of of capital.
None of this is to say that private equity firms never
improve the businesses that they buy.
Some do. But the industry's aggregate
returns, especially in recent years, suggests that operational
alpha is more aspiration than reality.
The real engine of private equity is just leverage, and in
a world of higher interest rates, that engine is starting
to sputter. Private equity has long sold
itself as a source of stability. In a world of whipsawing public
markets, private equity appears to offer smooth, upward, sloping
returns. The lines on the performance
charts are reassuringly linear. But as Cliff asness of AQ, or
famously put it, this isn't stability.
It's just stale pricing. The smoothing of returns in
private equity is by no means a bug.
It's a feature, and for quite some time has been a major
selling point. Because private assets aren't
marked to market, their prices don't fluctuate with daily
headlines or quarterly earnings like publicly listed stocks do.
Instead, they're occasionally appraised, often by the fund
managers themselves or by third parties hired by the fund
managers. This creates the illusion of low
volatility. I remember speaking to a private
equity fund manager during the credit crunch many years ago who
claimed that while every asset in the world had collapsed in
value, none of his portfolio companies had even ticked down.
The fact that these investments conceal their true volatility is
actually appealing to institutional investors bound by
solvency rules or performance metrics that penalize draw
downs. This illusion, however, comes at
a cost. As an article on the CFA
Institute website argues, the industry's reliance on, since
inception internal rate of return as a performance metric
is deeply misleading. IRR is not a rate of return in
any meaningful economic sense, in that it's not a return that
any private equity investor receives.
It's more of a mathematical artifact, highly sensitive to
the timing of cash flows and easily manipulated through
subscription lines, bridge loans, and delayed capital
calls. Consider a common tactic.
A fund identifies a deal but delays calling capital from
investors. Instead they use a short term
loan to finance the acquisition. This shortens the measured
holding period and inflates the IRR.
Even though the underlying economics haven't changed, the
fund looks like it's delivering a 25% return when in reality the
investors actual return and accounting for idle cash and
fees might be closer to 10%. The investors money has been
sitting in bonds waiting for the capital call and instead of
taking it the fund borrows money, often at a higher
interest rate just so they can show an artificially inflated
IRR. Then we have the proliferation
of continuation funds. These are vehicles that allow
APE Firm to sell an asset from one of its funds to another
fund. It also manages and charges fees
on the transaction, resets the clock, generates a paper gain in
the first fund, creating the appearance of a successful exit.
But the ACID hasn't changed hands in any meaningful way.
It's a bit like selling your house to yourself at a higher
price and declaring a profit. The Bain 2025 report notes that
nearly 30% of companies in buyout portfolios have undergone
some form of liquidity event, including secondaries, dividend
recaps, and NAV loans without a true exit.
These financial maneuvers generate cash flow and
flattering metrics, but they don't necessarily reflect real
value creation. This chart from Bloomberg shows
that over the last few years the business is held on to in
continuation. Funds are transferred at higher
valuations than the ones actually exited from through
sales. Investors are starting to notice
this. Distributions to paid in capital
DPIA, more grounded measure of actual cash returned, has become
the metric of choice for many limited partners, and by that
measure, the recent performance is underwhelming.
Funds launched in 2019 are only just breaking even, and some may
never get there. The smoothing of returns may
help investors sleep at night, but it also obscures risk,
conceals under performance, and makes it harder to distinguish
skill from luck. In the end, Volatility
laundering, as this technique has been named by Cliff Asness
at AQR, is just that, laundering.
In the end, it's not true stability.
It's opacity dressed up as sophistication.
Private equities promise of smooth returns is now colliding
with a hard reality. The industry is struggling to
convert paper gains into actual cash.
The backlog of unsold companies now exceeds $3.6 trillion across
nearly 30,000 portfolio firms. Distributions have slowed to a
crawl. Bain's report shows the
distributions as a percentage of net asset value have fallen to
11%, the lowest rate in over a decade.
The IPO market is comatose. Strategic buyers are cautious
and sponsor to sponsor deals once a reliable exit route are
now viewed with suspicion. Continuation funds, secondaries
and NAV loans have stepped in to provide liquidity, but they're
more account maneuvers than genuine exits.
Liquidity challenges are also distorting valuations.
When assets are never actually sold, you have to start
wondering about their carrying value.
Secondary market discounts, often 15% or more, reveal what
investors really think these assets are worth.
And that's before accounting for fees, leverage, and the time
value of money. The collapse of First Brands,
which I covered a few weeks ago and which is becoming a bigger
and bigger story, illustrates the fragility of the system.
First Brands borrowed heavily, pledged the same collateral
multiple times, and relied on opaque invoice financing
structures. When it failed, $2.3 billion in
assets simply vanished. Creditors are still trying to
trace the money. The parallels to Greensill are
fairly obvious and troubling. Private credit, which up until
now has been marketed as a disciplined alternative to bank
lending, now looks more like a blind spot.
The bespoke contracts and bilateral relationships that
were supposed to offer flexibility instead just
concealed problems. Pension funds and insurers who
invested now find themselves exposed to risks that they
barely understand. The liquidity crunch is also a
psychological reckoning. Investors are asking hard
questions. What are these assets really
worth? When will I get my money back?
Why does the fund keep reporting gains when they can't seem to
sell anything to outside investors?
Until those questions have better answers, the industry's
reputation for stability will remain under pressure.
The returns may still look smooth on paper, but the path to
realizing them is anything bad. In August, as I mentioned
earlier, Donald Trump signed an executive order that could
reshape the retirement landscape for millions of Americans.
The order allows 4O1K plan administrators to include
private equity and other alternative assets like
cryptocurrencies in defined contribution retirement plans.
The move was cheered by Apollo, Black Rock, Carlyle, and the
other firms that have spent years lobbying for access to the
growing retirement market. The pitch is that these assets
offer diversification, potentially higher returns and
access to institutional grade investments.
But the risks are less widely advertised.
Private equity funds come with high fees, long lock ups and
limited transparency. They're not priced daily and
they're not easy to exit for retail investors.
That's a very different proposition than buying an index
fund. The lobbying effort behind the
order was intense, according to financial disclosures.
Apollo and Carlisle pushed hard for regulatory changes.
Blackstone work through trade associations Mark Rowan of
Apollo argued that the retirement system was
overexposed to mega cap tech stocks.
We've basically leveraged the retirement system of the country
to NVIDIA, he said. The solution, in his view, was
to open the gates to private markets.
Some firms went further. The Defined Contribution
Alternatives Association reportedly argued that four O 1K
plans could be sued for not offering access to private
equity. Their logic being if PE delivers
higher returns then excluding it could be seen as a breach of
fiduciary duty. That argument may be legally
tenuous, but it reflects either the industries confidence or
desperation, and I'll let you be the judge of that.
The Bain report note that retail capital is now expected to drive
much of the industry's future growth.
Semi liquid products, target date funds and model portfolios
are being designed to mix public and private assets, and the big
private equity firms have all announced partnerships with
retirement plan providers. I'm not sure to what extent
American investors will fall for this pitch.
The one thing most investors have learned over the years is
that high fee investments reduce returns.
Average expense ratios paid by investors has been falling year
after year as investors refuse to pay up for underperformance.
The industry's push into four O 1 KS looks less like
democratization and more like a search for new capital.
When the existing investors are frustrated, I guess the trick is
to find new ones. When people from the world of
finance criticize private equity, they often focus on fees
and performance. But outside of the world of
finance, there's plenty of criticism over the industry's
impact on society. What happens when ownership is
distant? Incentives are misaligned.
And the goal is wealth extraction rather than growth
and customer focus. The moral critique centers on
the social consequences of financial engineering.
Congressional investigations into private equity owned dental
chains have raised questions about care quality and
unnecessary procedures being pushed on patients in the
pursuit of profits. Critics argue that the pursuit
of EBITDA Rd. can lead to antisocial outcomes from
understaffed care homes to hollowed out retailers.
Then there's also the antitrust concern around private equity
roll up strategies where PE firms by dozens of small
businesses in fragmented industries like doctors offices,
private schools, restaurants or student housing and then
consolidate them into platform companies.
The result can be reduced company petition and higher
costs for consumers. Private equity thrived in a
world of cheap debt. For most of its modern history,
the industry operated in a structurally falling interest
rate environment. That tailwind is now gone.
A huge component of the business model just relies on leverage.
When rates were near 0, that was cheap and effective.
But as interest rates have gone up over the last two years, the
cost of debt soared. Suddenly, the math doesn't work
that well. Higher rates mean higher
financing costs, lower valuations and fewer exits.
Sellers want yesterday's prices, while buyers can't afford them.
Many PE backed companies now carry 6 to 8 times EBITDA in
debt levels typically associated with junk credit.
When interest rates rise, bankruptcy risk rises with them,
and the private equity model starts to look a lot more
fragile. Private equity firms argue that
they can operate in any business environment.
But with inflation, tariffs, and policy uncertainty, all of which
hit smaller businesses harder than large businesses, it's
become increasingly difficult to underwrite new deals with any
confidence. Private equity has always
pitched itself as a sophisticated alternative to
public markets. It claims to offer
diversification, excess returns, and stability.
But the reality is more complicated than that.
The returns are driven by leverage, and the stability may
be an illusion, like a toddler's drawing of a roller coaster
labeled steady growth. The diversification?
Well, that's mostly concentrated bets on small, cyclical
businesses that panic at the side of higher interest rates as
the industry expands into four O 1 KS and retail products.
The pitch is being repackaged, but the fundamentals haven't
changed. The fees are high, the exits are
uncertain and the returns are shrinking.
Retail investors are being sold a feature, but they may instead
be buying a bug. The Mirage of sophistication is
powerful, but eventually the water seen in the distance has
to be real. And for private equity, that
means actual exits, actual distributions, and fewer
PowerPoint slides about transformational value creation.
Until then, the industry may look smooth on paper, but it's
starting to sound like a bedtime story told by someone who's
already spent your retirement. Thanks again for tuning into the
podcast. If you found it interesting, I'd
appreciate if you sent a link to a friend to help the podcast
grow. Have a great week and talk to
you again soon. Bye.