Private Equity: Separating Marketing Myth from Investable Reality
Private‑equity (PE) funds promise top‑tier returns, diversification and privileged access to “alpha.” Yet the data tell a more realistic story: net results that mirror public, levered, small‑cap value stock funds, sky‑high fees, very wide manager dispersion and accounting tricks that make performance look smoother than it is.
This note pulls together findings from Harvard Business School, AQR, McKinsey and others, then ties in an adjacent topics – the hazards of thematic funds – to show how product design, tax nuance and manager selection can quietly erode an apparently compelling idea.
| Source | Sample / Period | Key Finding |
|---|---|---|
| Stafford (2022), “Replicating Private Equity…” | U.S. buyout funds 1986-2016 | “Direct investments in private equity funds earn lower mean returns than a replicating strategy designed to mimic these key economic features of their investment process with public equities and brokerage loans” |
| Kaplan & Schoar (2005), J. Finance | PE funds globally, 1980–2001 | “Private equity funds earn returns comparable to public markets, but the variation in returns across funds is large, with the difference between the top and bottom performers often exceeding 20 percentage points annually.” |
| McKinsey Global Private Markets Review (2024) and Brown, Harris, Jenkinson & Kaplan (2021), J. Finance | 700+ institutions | “Extreme manager dispersion persists; access and selection dominate results.” (McKinsey) “Persistence of manager outperformance largely absent since early 2000s.” (Brown, Harris…) |
| Bao, Giannetti & Machiavello (2023), FAJ | BDCs 2006-2021 | When business development company (BDC) loans are marked to market rather than held at manager-reported NAV, measured alpha shrinks from +2.7% to approximately 0%.” (Bao, Giannetti & Machiavello, 2023, FAJ, sample: BDCs 2006–2021) |
Fees & Gaming Performance
Here’s a quick explanation with quotes directly from different academic sources that explain some of the “tricks” and “features” of private equity:
- All‑in drag: “Buyout funds typically charge management fees of around 2% per year, carried interest [performance fee] of 20% on returns above an 8% hurdle, and additional fund-level expenses, resulting in a substantial annual cost to investors.” (Phalippou, 2020; Ang et al., 2018).
- Performance Illusion: “The internal rate of return (IRR) metric used in private equity is affected by the timing of cash flows, which managers can strategically influence, making reported returns potentially misleading.” (Kaplan & Schoar, 2005; Ang et al., 2018).
- Persistence is gone: “Persistence in private equity fund returns diminished significantly after 2000, indicating past top-performing funds do not reliably predict future outperformance.” (Harris, Jenkinson & Kaplan, 2021).
This means that you cannot simply look at the funds that have previously done well, and expect them to continue to do well – further confirmed by Morningstar below with the recent rise of Thematic funds
The allure — and trap — of thematic funds
Just as PE markets chase narratives (“tech buyouts,” “longevity economy”), retail fund shops package trends into funds. An interesting Morning Star paper shows that survivorship bias is severe and that chasing the latest hot topic or fund often gets you burned – fewer than half of the thematic funds launched in 2000–2019 still exist (Morningstar, 2020).
Lesson: Whether private or public, story‑based capital allocation usually enriches managers, not investors.
Manager selection: a minefield you pay for
Academic work keeps reminding us that the real story in private-equity is manager-selection risk (not the asset class itself).
McKinsey’s 2024 Global Private Markets Review shows the spread between top- and bottom-quartile PE funds over a rolling 10-year window is still north of 10 percentage points a year – meaning your choice of fund can swamp any notional “PE premium.”
And, unlike public equities (where you can default to a low-cost index fund), there is no inexpensive, diversified wrapper for private equity; access comes only through high-fee limited partnerships or feeder funds.
Thorough due-diligence on style drift, leverage and key-person risk inherently tilts the field toward large institutions with in-house teams to vet managers and negotiate terms. Most individual investors must pay yet another layer of costly intermediaries, eroding whatever thin, net-of-fee edge private equity might have offered in the first place.
Public‑market substitutes: same risk, lower cost, daily liquidity
The above data shows that constructing a 60% small‑cap value fund + 40% BB‑rated corporate‑bond fund portfolio, levered 1.3x, had replicated U.S. buyout return drivers with:
- Significantly lower expense ratios (<0.25%)
- Zero lock‑ups, full transparency
- Ability to harvest tax losses annually – almost impossible in PE
Bottom line:
Private equity once harvested a true scarcity premium. Today asset bloat, fee drag and sophisticated replication erase that edge. Add in opaque valuation, aggressive performance metrics and daunting manager dispersion, and investors may potentially be better suited with sticking to a mix of more liquid investments, like small‑cap value equity funds, and corporate credit (among others) combined with smart tax planning. Save the 5 % fee – and the next decade of capital lock‑up – for potential opportunities where the data still justify the sacrifice.
Disclosures:
Private equity and other investment strategies discussed may not be suitable for all investors. Investment decisions should be based on individual objectives, risk tolerance, time horizon, and financial circumstances.
Important information about mutual funds is found in the Fund Facts document. Please read this carefully before investing. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Unit values and investment returns will fluctuate.
The information provided is based on current laws, regulations and other rules applicable to Canadian residents. It is accurate to the best of our knowledge as of the date of publication. Rules and their interpretation may change, affecting the accuracy of the information. The information provided is general in nature and should not be relied upon as a substitute for advice in any specific situation. For specific situations, advice should be obtained from the appropriate legal, accounting, tax or other professional advisors.
References:
- Phalippou, L. (2020). Private Equity Laid Bare.
- Ang, A., Chen, B., Goetzmann, W., & Phalippou, L. (2018). “Estimating Private Equity Returns from Limited Partner Cashflows.” Review of Financial Studies.
- Stafford, E. (2022). Replicating private equity with value investing, homemade leverage, and hold-to-maturity accounting. The Review of Financial Studies, 35(1), 299–342. https://doi.org/10.1093/rfs/hhab02
- McKinsey & Co. “Global Private Markets Review 2024.” (Annual industry report).
Examine the structure. Understand what you own.
And remember: complexity often benefits the seller, not the buyer.
