Grant Kettering’s critique of Coin-Flip Capitalism defends private finance as “a major competitive advantage and source of comprehensive national power.” In his view:
In alliance with other sectors such as government- and academically-funded scientific research institutions, private funds have served effectively as tutors to companies pursuing American innovation in absolutely foundational areas such as semiconductors (Intel) and information technology (Apple, Google) as well as contributors to the depth and breadth of U.S. capital markets, lowering our national cost of capital and helping to ensure that the dollar maintains its privileged status as the primary global reserve currency. Viewed in a comparative and historical perspective, it is not an exaggeration to say that the private fund industry has been one of the primary enabling sources of American comprehensive national power over the last 70 years, having transformed small company finance from the province of half-baked club deals or matters of oligopolistic or mercantilist activity into a serious, market-driven institution that has produced manifest results [emphasis in original].
I don’t disagree with this history. The problem is that it is history. It’s no accident that his examples are decades old. And it rather begs the question to celebrate a “primary enabling source of American comprehensive national power” during a period in which that power is eroding.
Today’s private-sector venture capital model embodied in Silicon Valley is not meeting our current economic challenges. “We wanted flying cars,” Peter Thiel is fond of saying, “instead we got 140 characters.” While other nations invest heavily in world-leading manufacturing sectors and strategically important emerging technologies like 5G, the Silicon Valley has busied itself “disrupting” established industries while failing to build sustainable businesses in their stead, financing unicorn apps with no clear ability to achieve sustainable profits. China has developed an ambitious strategy to further enhance its industrial capacity while the financialization of American firms cripples our ability to innovate—even in areas where the U.S. was once a world-leader.
Private finance has contributed to these long-term trends and undermined our economic vitality. Kettering spotlights neoliberal economic policy—especially trade liberalization—as the primary culprit for our nation’s economic challenges. But our financial system is part and parcel of that agenda and, to use Kettering’s phrase, a primary enabling source of it. Meanwhile, private equity funds, as he notes, routinely saddle companies with debt, strip their assets, and even bankrupt them.
If there were a defense for the practices of private funds, it would have to be that they reflect market imperatives; that, while perhaps harmful to the national interest, they are behaving “efficiently.” The benefits of that efficiency might flow to the nation through higher investment returns for pensioners and universities.
The data do not support such a defense. The Returns Counter shows the private equity funds have struggled to consistently outperform the S&P 500 over one-, three-, five-, and ten-year time horizons. Venture capital, meanwhile, performed inconsistently against the S&P 500, trailing the index over the preceding decade, but outperforming it over the one- and five-year time horizons.
These are not metrics chosen “out of convenience” to generate “artificial” results, as Kettering alleges. They are the same metrics used by the private equity industry’s own trade association. The Returns Counter’s main empirical finding is well-documented elsewhere. A recent analysis by managers of the Abu Dhabi Investment Authority and the Canadian Pension Plan finds that, on a risk-adjusted basis, private equity buyout funds have lagged public markets in every vintage from 2006 to 2014. Even The Wall Street Journal has shown that private equity returns have struggled to beat the S&P 500 since the mid-2000s.
A new paper provides especially compelling corroborating evidence. Ludovic Philappou of Oxford’s Saïd School of Business finds that private equity has performed in line with public equity indices, such as the S&P 500 Total Return, going back at least to 2006. The paper, recently featured in Institutional Investor and the Financial Times, shows that buyout funds have only very slight outperformed—by 1% per year—the S&P 500 for 2006-2015 vintages. Prior to 2006, private equity vintages have been shown to outperform public market benchmarks, but Phalippou has elsewhere found that this is largely attributable to the studies’ preferred benchmarks.
Mediocre returns characterize not only the private equity industry as a whole, but even its leading firms and largest investors. Phalippou calculates the return multiples that private equity investors received for 2006-2015 vintages. The average net return across all private equity funds is just below $1.60 for every $1 invested (1.55-1.57x) or 11% per year, the same as a typical public-equity index over the same period. The “Big Four” private equity firms—Apollo, Blackstone, Carlyle, and KKR—generated roughly the same net returns.
This has meant subpar returns for the largest investors. Of the fifteen largest public pension funds in the U.S., the five that provide in-depth performance data report a net return of $1.50 for every $1 invested (1.51-1.54x) – slightly below that of all private equity funds as well as the stock market. Another recent paper has found that public pension funds have underperformed passive investments, such as index funds, by roughly 1% per year. As Phalippou concludes:
It makes no difference how much [the pension funds] have spent on their consultants (or who their consultants have been); what their Strategic Asset Allocation has been; how large their PE portfolio is; how much access they have to top-quartile PE firms; or how long they have been investing in PE …. They have all ended up with the same net performance: just below average.
Or, as he told the Financial Times, “This wealth transfer from several hundred million pension scheme members to a few thousand people working in private equity might be one of the largest in the history of modern finance.” This, Bain & Company has noted, “is not what PE investors are paying for.” Yet firms continue to collect their fees. Phalippou estimates that private equity firms collected an estimated $230 billion in fees from 2006-2015.
Something is amiss. Private funds are failing to deliver on their claims of either upstream value to investors or downstream value to the nation, yet capital continues to pour in. The answer likely lies, as Kettering admits, in the very design of private funds and their conflicts of interest between fund managers and investors.
So I thank Kettering for his thoughtful comments. But instead of protesting with “why go after us?” more industry practitioners ought to think about the roadmap to a financial system that channels capital toward our nation’s economic challenges. As in our history, America’s future competitiveness may depend on it.