Warren Buffett versus Private Equity

Warren's well publicised dislike of private equity has featured in the press again this week.  Over the years he has attacked four aspects of the industry:

1.  Excessive use of leverage which can result in the destruction of quality businesses.

2.  Short hold periods and a resulting focus on exit strategies rather than building long term value.

3.  Stripping out profits by imposing burdens such as transaction fees and monitoring fees.

4.  The 2% / 20% compensation model. 

I agree with him on all counts, though I think he's guilty of carelessly lumping all private equity activity into a single axis of evil.  When Warren complains about LBO firms and private equity he's really referring to the global buyout firms which emerged over the past decade (think Blackstone, Carlyle, KKR, CVC) rather than old fashioned mid-market private equity.

Excessive use of leverage became the defining feature of the global buyout game.  As more and more cheap leverage became available the prices these funds paid for deals rocketed while the equity component shrank.

By contrast, mid-market debt multiples rarely went above 4x EBITDA, even at the height of the boom.  Many mid-market deals were being leveraged 3x EBITDA while the buyout guys were pumping 8x or more into their acquisitions.

Likewise, the charging of large transaction or monitoring fees is a practice almost exclusively seen in the buyout sector.  I don't totally agree with Warren that this is an evil practice.  It's true that the amount of money going into the GP's pocket can reach offensive levels (2% of a $5 billion transaction!), but the reality is that buyout funds usually own all or most of the equity in their portfolio companies.  So it's their money [their LP's money, to be precise].  Whether profits are taken out as dividends or as monitoring fees is irrelevant to the health of the portfolio company.  Last time I looked Warren was very happy to receive dividend cheques from Berkshire's portfolio.

Finally, I'd argue that the 2% / 20% model is like democracy.  It's a lousy system but better than all the other ones.  However, the large global buyout funds have abused the model . . . it's become democracy Zimbabwe style.  

Traditionally the 2% management fee was supposed to keep the lights on and pay the staff.  When funds were smaller the General Partners only built personal wealth if the portfolio companies performed  . . .  they were therefore fully aligned with their limited partner investors.  Today, with funds in the tens of billions, GPs are becoming wealthy on fees alone, regardless of how the portfolio performs.  That needs to change.

A final word:  let's not forget that Warren is increasingly competing with private equity firms when he tries to scoop up businesses.  The Deal.com puts it nicely:

Buffett may be the perfect buyer for some companies. But he often wants to pretend that he should be the only buyer, that his way is the only way and that, given his self-evident (and assiduously self-promoted) virtue, he should not face competition. Again, you can't argue with his record, but you can wonder about his moral self-regard and where his wisdom ends and his self-interest begins.

 

Comments

[Sir David Walker]

Since the December 08 many of the UK mid-market firms now have a debt multiple of well over 5x

[GetUrFactsStraight]

He called it a "porn" shop! Not a PAWN shop

[GetYOURFactsStraight]

Hard to know for sure if Warren really meant "porn" or "pawn". They sound the same so the journalists reported it as "porn". But he was talking about a buyer who purchases an asset forever versus a buyer who purchases it and then QUOTE: "he'll stick it up in the window, and some other guy will come along in a raincoat, and he'll buy it." That sounds to me like he meant a PAWN shop.

So GP might be right. Only Warren knows for sure.

[Vanessa]

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