Private Equity and Pension Funds: A Call for Fairer Compensation Structures

Private Equity and Pension Funds: A Call for Fairer Compensation Structures

Private Equity investments have been a subject of recent debate, raising questions about the fairness of compensation structures within the financial industry. Recently, we interviewed Professor Ludovic Phalippou of the Said Business School, University of Oxford on this topic. Professor Phalippou is one of the leading experts in Financial Economics. He also is one of the lecturers in the program ‘Certified Pensioenexecutive Vermogensbeheer’ of the Erasmus University Rotterdam.

In this article, Phalippou sheds his light on the role of Private Equity (PE) in the financial sector. He emphasizes the need for better financial education of citizens and collaboration among like-minded pension funds.

Unveiling the Private Equity Billionaire Factory

Phalippou’s research indicates a strong proliferation of billionaires within the Private Equity industry: the number of multibillionaires grew from 5 to 22 between 2005 and 2020. Phalippou: “These billionaires were able to get rich due to the unprecedented high fees that are charged in Private Equity. We have never seen that in the history of financial markets. My research shows that the returns after fees are even lower compared to public market investments.” Phalippou wants to clarify that he has never advocated against investing in Private Equity. On the contrary: “My purpose is to give the right numbers to the people, such that they can decide what they want. They still can have perfectly good reasons to invest in Private Equity.”

A Breach of the Social Contract

The real problem is not the excessive fees that are charged by Private Equity firms, but the one-sided compensation structures that are prevalent in the financial industry. Phalippou draws the comparison with a casino. “I can say to all gamblers: ‘Look, I’m your consultant. We are going to play together and each time you win, I will 10% of your gains because you won because of my good advice. If you lose, well, that’s bad luck.’ If I will sign this contract, I will make a lot of money. I would be seriously rich quickly,” Phalippou smiles.

The CEO of Schiphol

This stark contrast between the upside and downside of compensation creates a breach in the social contract and raises concerns about fairness and accountability. Phalippou: “Take the CEO of Schiphol. He is very well paid and gets bonuses etcetera. This person clearly messed it up last year, right? What happened to this person? He is fired now and he has a bad reputation? What is the downside? When you pay a person a lot of money because he has exceptional qualities and because he can add value, why is this person not liable when he destroys value?”

Rebuilding Trust in the Financial Sector

These practices have generated skepticism and frustration among citizens. According to Phalippou, it is understandable to a certain extent that top athletes like Kylian Mbappé earn significant salaries because they have exceptional skills. On the contrary, it is more challenging for individuals to comprehend the astronomical salaries in finance. Phalippou believes that a lack of financial education contributes to this problem. “Many people have limited knowledge of finance. This enables financial experts to take advantage of their ignorance.” Therefore, the professor believes that educating the public in finance is crucial to bridge the understanding gap and ensure a fairer financial system.

Collaboration Between Pension Funds

According to the professor, pension funds can play a crucial role in establishing more fair compensation models that align incentives with both positive and negative outcomes. Phalippou encourages like-minded pension funds to collaborate. “The Dutch and the Scandinavian pension funds are very much on the same page regarding this topic. By actively participating in organizations like the Institutional Limited Partners Association (ILPA), pension funds can amplify their voice and advocate for necessary improvements in the industry.”  Phalippou points also to successful examples in the United States where pension funds worked with some Private Equity firms to introduce alternative fee models based on budgets. By combining efforts and engaging with the industry, pension funds can strive for improved governance and fee structures. Pension Funds can play a role in the financial education of the public as well, according to the professor. Apparently, collaboration and communication are the main keys to a fairer financial system.

Wil je meer weten over de Pensioenexecutive opleidingen van de Erasmus Universiteit Rotterdam? Bezoek de website of stuur je vraag naar esaa-pensioenen@ese.eur.nl