Warren Buffett - This is why Private Equity market is struggling

Key takeaways at the end

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Some years back our competitors were known as “leveraged-buyout operators.” But LBO became a bad name. So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage. 

Their new label became “private equity,” a name that turns the facts upside-down: A purchase of a business by these firms almost invariably results in dramatic reductions in the equity portion of the acquiree’s capital structure compared to that previously existing. A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers. 

Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating. The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need. Instead, they’re keeping their remaining funds very private.

2008 Shareholder Letter

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In truth, “equity” is a dirty word for many private-equity buyers; what they love is debt. And, because debt is currently so inexpensive, these buyers can frequently pay top dollar. Later, the business will be resold, often to another leveraged buyer. In effect, the business becomes a piece of merchandise. [...]

[...] The amount that a private-equity purchaser offers to the seller is in part determined by the buyer assessing the maximum amount of debt that can be placed on the acquired company. 

Later, if things go well and equity begins to build, leveraged buy-out shops will often seek to re-leverage with new borrowings. They then typically use part of the proceeds to pay a huge dividend that drives equity sharply downward, sometimes even to a negative figure. 

2014 Shareholder Letter

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The effects of this laxity were felt last year in a ballooning of defaults. In this environment, “financial” buyers of businesses – those who wish to buy using only a sliver of equity – became unable to borrow all they thought they needed. What they could still borrow, moreover, came at a high price.

[...] Consequently, LBO operators became less aggressive in their bidding when businesses came up for sale last year. Because we analyze purchases on an all-equity basis, our evaluations did not change, which means we became considerably more competitive.

2000 Shareholder Letter

* Bold emphasis added

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Key concepts and takeaways:

• Debt-driven market: The Private Equity deal flow is dependent on the amount of leverage that can be used in an acquisition. This in turn is driven by the general level of interest rates. As PE firms are trying to maximise leverage, higher interest rates will mathematically result in lower price they will be willing to pay for a business. Most recently, deal activity has been impacted by the interest rates increase in 2022. A valuation gap emerged between sellers, still demanding pre-2022 valuation levels, and buyers, who have been facing higher cost of debt at current rates. 

• Debt markets do shut down: During more severe downturns, debt markets can shut down completely for a period of time. This not only hinders new acquisitions, but also puts pressure on existing investments as some companies are not able to refinance their debt, which might lead to defaults.