This August, President Trump signed an executive order allowing private equity firms to tap into America’s 401(k) 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, Ares, and TPG are all in double-digit decline. Blackstone is down too, with Carlyle and 3i being outliers, up more than the S&P. It turns out - that letting retail investors into the sandbox doesn’t 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 are 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 401(k)s 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 Seven minus Tesla plus Broadcom — which make up more than a third of the index. These firms are growing earnings, throwing off cash, and doing it with less leverage than their predecessors in the dot-com era. Investors have been paying up for profitability, and the market has been rewarding them.

Private equity doesn’t own these companies – and it doesn’t own anything like them. 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 market, adjusted for the additional leverage. But that relationship breaks down when the market is being driven by a narrow set of megacap 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 for. Investors are not interested in paying top dollar for slow-growth businesses with heavy debt loads — and that’s making it 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 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 percent leverage — far more than you’d find in a publicly listed company, where debt-to-equity ratios tend to hover around 30 percent.

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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 easier to borrow against – no one wants to lend money to a business with negative – or even highly variable cashflows. 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. They 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 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 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 60–75% debt — significantly more than the 30% average for public companies. That leverage amplifies returns when things go well. 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 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 they’re replacing 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 may be surprised to hear - that margin expansion rarely materializes. Bain’s 2025 global private equity report shows that in the software businesses 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 Ludovic Phalippou 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 gamed 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 often 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 zero-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 capital.

None of this is to say that private equity firms never improve the businesses they buy. Some do. But the industry’s aggregate returns — especially in recent years — suggest that operational alpha is more aspiration than reality. The real engine of private equity is 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 AQR 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 them. This creates the illusion of low volatility – I remember speaking to a Private Equity fund manager during the credit crunch – 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 drawdowns.

This illusion – however - comes at a cost. As an article on the CFA Institute’s website argues - the industry’s reliance on since-inception internal rate of return (IRR) as a performance metric is deeply misleading. IRR is not a rate of return in any meaningful economic sense – in that it is not a return that any private equity investor receives. It’s more of a mathematical artefact, 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 investor’s actual return — accounting for idle cash and fees — may 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 (at a higher interest rate) just so that they can show an artificially inflated IRR.

Then there’s the proliferation of continuation funds. These are vehicles that allow a PE 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 asset 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 businesses held on to in continuation funds are transferred at higher valuations than the ones actually exited from. Investors are starting to notice. Distributions to Paid-in Capital (DPI) — a more grounded measure of actual cash returned — has become the metric of choice for many limited partners. And by that measure, the recent vintages are 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 underperformance, 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 equity’s 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 2025 report shows that 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. 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 accounting 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 dollars in assets simply vanished. Creditors are still trying to trace the money. The parallels to Greensill are 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 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 but.

In August, Donald Trump signed an executive order that could reshape the retirement landscape for millions of Americans. The order allows 401(k) plan administrators to include private equity and other alternative assets – like cryptocurrencies - in defined contribution retirement plans. The move was cheered by Apollo, BlackRock, Carlyle, and 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 lockups, 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 Carlyle pushed hard for regulatory changes. Blackstone worked through trade associations. Marc Rowan of Apollo argued that the retirement system was overexposed to megacap 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 401(k) 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 industry’s confidence — or desperation – I’ll let you be the judge of that.

The Bain 2025 report notes that retail capital is now expected to drive much of the industry’s future growth. Semiliquid 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 industries push into 401(k)s looks less like democratization and more like a search for new capital. When the existing investors are frustrated, find new ones. When people from the world of finance criticize private equity, they often focus on fees and performance. But outside the world of finance there is 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 growth can lead to anti-social outcomes — from understaffed care homes to hollowed-out retailers.

There is also antitrust concern around private equity roll-up strategies, where PE firms buy dozens of small businesses in fragmented industries — like doctors’ offices, private schools, restaurants, or student housing — and consolidate them into platform companies. The result can be reduced competition 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 relies on leverage. Buyout firms typically finance acquisitions with 60–75% debt. When rates were near zero, 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 six to eight 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 small businesses harder than large businesses it has 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 rollercoaster labeled “steady growth.” The diversification – well that’s mostly concentrated bets on small, cyclical businesses that panic at the sight of higher interest rates.

As the industry expands into 401(k)s 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. If you found this video interesting, you should watch my recent video on the sudden collapse of First Brands Group and what it might mean for the two trillion dollar leveraged loans market. Don’t forget to check out our sponsor Lovable using the link in the description and talk to you in the next video – bye.