Apples and Oranges: Benchmarking Games and the Illusion of Private Equity Outperformance

Discover how benchmarking and sector composition impact private equity returns and fees

Paper reviewed:

Phalippou, Ludovic, Apples and Oranges: Benchmarking Games and the Illusion of Private Equity Outperformance (June 02, 2025). Available at SSRN: https://ssrn.com/abstract=5278859 or http://dx.doi.org/10.2139/ssrn.5278859

Summary

A recent study reveals that private equity's outperformance largely disappears when consistent benchmarks are applied, highlighting the need for standardized benchmarking and transparent reporting. The research also uncovers the significant impact of sector composition on returns and the persistence of high fees despite market-level returns.

Key Findings

• Private equity's reported outperformance over public markets largely disappears when consistent benchmarks and definitions are applied; the average Public Market Equivalent (PME) values remain near parity with appropriate public equity indices.
• The apparent alpha in Europe and across sub-strategies often reflects sector composition and benchmark selection rather than superior value creation. For instance, European private equity's outperformance is largely due to its heavier exposure to sectors like technology and healthcare, compared to public equity indices that are weighted toward underperforming sectors like banking and industrials.
• The persistence of high fees in the private equity industry, despite market-level returns, highlights the need for standardized benchmarking and transparent reporting. A back-of-the-envelope calculation suggests that general partners captured around $1 trillion in fees from $6.5 trillion invested in private capital funds across the 2000–2019 vintage years.
• The choice of benchmark significantly influences the perceived performance of private equity. Switching from the S&P 500 to more favorable benchmarks like the Russell 2000 or MSCI ACWI can artificially inflate private equity's relative performance.
• The returns of private equity funds are broadly in line with public markets in the US and probably in Europe, with a pooled IRR of 10.75% and a TVPI of 1.51x for the funds in the sample.

Implications

Business and Policy Implications

• Investors and asset owners should be cautious of selective benchmarking practices that inflate private equity's performance and should demand more transparent reporting.
• Policymakers and regulators should consider standardizing benchmarking practices across the private equity industry to ensure fair comparisons.
• The justification for high fees in the private equity industry is weakened if returns are not consistently above those of public markets; this could lead to downward pressure on fees.
• Institutional investors may need to reevaluate their allocation strategies to private equity, focusing more on diversification rather than return enhancement.
• The industry's economics could shift, benefiting smaller and more specialized funds, and redirecting capital toward more transparent and cost-effective vehicles.

Introduction

The notion that private equity (PE) delivers superior returns compared to public equity markets has been a driving force behind the significant institutional investment in private capital over the past two decades. As of 2024, large asset owners such as pension funds and sovereign wealth funds typically allocate 15% to 25% of their portfolios to PE, attracted by the promise of higher, less volatile, and uncorrelated returns. However, this narrative is increasingly being challenged by research suggesting that much of the perceived outperformance is due to flawed interpretations and inconsistent benchmarking practices.

Background and Context

The private equity industry has grown substantially, with investors seeking alternative sources of returns. Previous research has highlighted issues with how private equity performance is measured and reported. The flexibility in defining what constitutes "private equity" and the choice of benchmark indices have been identified as key factors influencing perceived performance. This paper updates the analysis using the latest data from the MSCI Private Capital Universe, examining 7,858 funds with $6.5 trillion in capitalization across the 2000–2019 vintage years.

The study reveals that the pooled IRR for these funds is 10.75%, with a Total Value to Paid-In (TVPI) ratio of 1.51x, figures that are consistent with market-level returns. Notably, the Public Market Equivalent (PME), a measure that compares private equity returns to those of public markets, stands at 0.99 when using the S&P 500 as a benchmark. This indicates that, on average, private capital funds performed in line with the S&P 500.

A closer examination of the data and benchmarking practices reveals several critical insights. The definition of private equity can be flexible, encompassing or omitting various investment types such as real assets and private debt. This flexibility allows for the adjustment of definitions to suit favored narratives, potentially inflating the relative attractiveness of PE. For example, excluding real assets and private debt from PE performance analyses can improve headline performance, albeit modestly, with the PME rising to 1.08.

The choice of benchmark is another crucial factor. Historically, the S&P 500 was used as a comparator for private equity, justified by the notion that large institutional investors were limited to the largest and most liquid public equities. However, this rationale has been questioned, and the industry has shifted towards using other indices like the Russell 2000 and MSCI ACWI. This shift is not neutral; switching to these benchmarks can significantly alter the perceived performance of private equity.

Benchmarking and Performance

The analysis of US stock returns over nearly a century, using data from the Ken French data library, shows a clear decline in average returns across size deciles, from 17.9% for the smallest firms to 11.6% for the largest. Over the past 25 years, returns across different size categories have clustered closely together, with the overall average return being nearly identical to the pooled IRR reported for private equity.

The performance of large-cap US stocks has varied significantly over time. During the 2000s, they posted slightly negative returns, a phenomenon without precedent in the century-long dataset. In contrast, over the past 15 years, large-cap stocks have produced markedly higher returns, effectively reversing the size premium. The Russell 2000, a commonly cited benchmark for private equity, has delivered an average return of just 9% over the past 15 years, lower than any of the size-based decile portfolios.

Sector Composition and Regional Differences

The apparent outperformance of European private equity over public markets is largely attributed to sector composition rather than superior value creation. European public equity indices are heavily weighted toward underperforming sectors like banking and industrials, whereas European private equity portfolios are more exposed to sectors like technology and healthcare. This disparity suggests that the observed outperformance may not be sustainable if European public equities undergo a sectoral rebound.

Fee Structure and Value Distribution

A detailed analysis of the distribution of economic gains generated by private capital funds reveals that general partners captured around $1 trillion in fees from $6.5 trillion invested across the 2000–2019 vintage years. This significant transfer of value to PE fund managers raises ethical and fiduciary questions, particularly given that private equity returns are largely in line with those available in public markets.

The findings of this research have far-reaching implications for investors, policymakers, and the private equity industry. As the industry moves forward, there is a growing need for standardized benchmarking practices, transparent reporting, and a reevaluation of fee structures. The next part of this series will delve deeper into the implications of these findings for investors and the broader financial industry.

Main Results

The study "Apples and Oranges: Benchmarking Games and the Illusion of Private Equity Outperformance" by Ludovic Phalippou presents a comprehensive analysis of private equity (PE) performance relative to public markets. The main findings indicate that the perceived outperformance of PE is largely an illusion created by inconsistent benchmarking and data filtering.

Performance Comparison

The research examines a dataset of 7,858 private capital funds with $6.5 trillion in capitalization across the 2000–2019 vintage years. The pooled Internal Rate of Return (IRR) is 10.75%, and the Total Value to Paid-In (TVPI) is 1.51x, consistent with market-level returns. The Public Market Equivalent (PME) stands at 0.99 when using the S&P 500 as a benchmark, indicating that PE performance is broadly in line with public markets.

Benchmarking and Sector Composition

The study highlights the impact of benchmark selection on perceived PE performance. Narrowing the definition of PE and switching to benchmarks like the Russell 2000 or MSCI ACWI can significantly alter the PME, making PE appear to outperform public markets. For instance, using the MSCI World index instead of the S&P 500 increases the PME to 1.16. The research also reveals that sector composition plays a crucial role in the apparent outperformance of PE in certain regions, such as Europe.

Regional Variations

The performance differential between PE and public markets varies across regions. In the US, the PME hovers around 1.0, indicating parity between asset classes. In contrast, European PE appears to outperform public markets more convincingly, with a PME of approximately 1.15 when compared to the MSCI Europe index. However, this outperformance is attributed to the weaker performance of European public equity indices, which are heavily weighted toward underperforming sectors.

Methodology Insights

The research employs a rigorous methodology, utilizing a large dataset of private capital funds from the MSCI Private Capital Universe. The study's approach is innovative in its detailed examination of benchmarking practices and sector composition. By analyzing nearly a century of US stock returns by size decile, the research provides valuable insights into the historical performance of different market segments.

The use of the PME as a benchmarking metric allows for a more nuanced comparison between PE and public markets. The study's findings underscore the importance of consistent and transparent benchmarking practices in evaluating PE performance.

Analysis and Interpretation

The findings of this research have significant implications for investors, policymakers, and the PE industry. The revelation that PE returns are largely in line with public markets challenges the conventional narrative surrounding PE outperformance. The $1 trillion transfer of value to PE fund managers, despite market-level returns, raises ethical and fiduciary concerns.

The study's results suggest that the justification for high fees in the PE industry is weak. As the industry moves forward, there is a growing need for:

• Standardized benchmarking practices
• Transparent reporting
• Reevaluation of fee structures

The next part of this series will explore the implications of these findings for investors and the broader financial industry, including potential shifts in allocation strategies and the economics of the PE industry.

Some key takeaways for business leaders and investors include:

• The need to critically evaluate PE performance claims and benchmarking practices
• The importance of considering sector composition and regional variations when assessing PE performance
• The potential for a shift in allocation strategies, with a greater emphasis on diversification and cost-effectiveness
• The likelihood of downward pressure on fees in the PE industry, benefiting smaller and more specialized funds.

Practical Implications

The findings of this study have significant implications for businesses, investors, and the broader financial industry. The revelation that private equity (PE) returns are largely in line with public market returns, once consistent benchmarks and definitions are applied, challenges the conventional wisdom that PE is a superior asset class.

Real-World Applications

The study's results have far-reaching consequences for institutional investors, such as pension funds and endowments, which have allocated significant portions of their portfolios to PE. These investors must reassess their allocation strategies and consider the true value proposition of PE investments.

• Investors should critically evaluate PE performance claims and benchmarking practices to ensure they are making informed decisions.
• A more nuanced understanding of sector composition and regional variations is essential when assessing PE performance.
• The potential for a shift in allocation strategies, with a greater emphasis on diversification and cost-effectiveness, may lead to a more efficient allocation of capital.

Strategic Implications for Businesses and Managers

The study's findings have significant implications for PE firms, investors, and the broader financial industry.

• PE firms must adapt to a more transparent and standardized benchmarking environment, which may lead to downward pressure on fees.
• Investors must reevaluate their fee structures and consider the true cost of PE investments.
• The industry may experience a shift towards more specialized and cost-effective funds, benefiting smaller players.

Who Should Care About These Findings and Why

• Institutional investors: Pension funds, endowments, and sovereign wealth funds must reassess their allocation strategies and consider the true value proposition of PE investments.
• Private equity firms: PE firms must adapt to a more transparent and standardized benchmarking environment, which may impact their fee structures and business models.
• Financial industry professionals: The study's findings have implications for the broader financial industry, including asset managers, consultants, and regulators.

Actionable Recommendations

To navigate the changing landscape, businesses and managers can take the following specific actions:

1. Reevaluate benchmarking practices: Adopt standardized and transparent benchmarking practices to ensure accurate performance assessments.
2. Assess sector composition and regional variations: Consider the impact of sector composition and regional variations on PE performance when making investment decisions.
3. Renegotiate fee structures: Investors and PE firms should reassess fee structures to ensure they are aligned with the true value proposition of PE investments.
4. Diversify allocation strategies: Investors should consider diversifying their allocation strategies to include more cost-effective and transparent investment vehicles.

Implementation Considerations

When implementing these recommendations, businesses and managers should consider the following:

• Data quality and availability: Ensure access to high-quality and reliable data to support informed decision-making.
• Regulatory environment: Stay abreast of regulatory developments and potential changes to the regulatory environment.
• Industry dynamics: Monitor industry trends and adapt to changes in the competitive landscape.

Conclusion

The study's findings have significant implications for businesses, investors, and the broader financial industry. By understanding the true nature of PE returns and adopting more transparent and standardized benchmarking practices, investors can make more informed decisions and optimize their allocation strategies.

Summarize the Main Takeaways

• PE returns are largely in line with public market returns when consistent benchmarks and definitions are applied.
• The industry must adopt more transparent and standardized benchmarking practices.
• Investors should reassess their allocation strategies and consider the true value proposition of PE investments.

Final Thoughts on Significance and Impact

The study's findings have far-reaching consequences for the financial industry, highlighting the need for a more nuanced understanding of PE performance and the importance of transparent and standardized benchmarking practices. As the industry adapts to these changes, investors and PE firms must be prepared to evolve their strategies and business models to remain competitive.