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Buffett on private equity:[a] > For some years, these purchasers accurately called themselves “leveraged buyout firms.” When that term got a bad name in the ea
by cs702 7y ago
Buffett on private equity:[a]
> For some years, these purchasers accurately called themselves “leveraged buyout firms.” When that term got a bad name in the early 1990s – remember RJR and Barbarians at the Gate? – these buyers hastily relabeled themselves “private-equity.” The name may have changed but that was all: Equity is dramatically reduced and debt is piled on in virtually all private-equity purchases. Indeed, 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. 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.
Left unsaid is what happens if things do not go well. Saddled with as much debt as possible, the business by design has been put in a position such that it cannot survive even a modest decline in revenue without raising significant additional capital.
Therefore, if government assistance is not forthcoming, the economic shock of COVID-19 looks likely to put a majority of leveraged buyouts in bankruptcy.
[a] https://www.berkshirehathaway.com/letters/2014ltr.pdf https://www.berkshirehathaway.com/letters/2014ltr.pdf
- Retric 7y ago> majority of leveraged firms into bankruptcy. I am unsure how this is different from the normal failure of leveraged firms. When so many are failing within 3 years in normal times, this just seems to be more of the same.
- omgwtfbyobbq 7y agoI don't think it is different. At the same time, I wouldn't think most firms accrue as much debt normally as PE firms do when they buy them out.
- dcolkitt 7y ago> Saddled with as much debt as possible, the business by design has been put in a position such that it cannot survive even a modest decline in revenue without raising significant additional capital. I agree, but I think it's important to qualify what you mean when you say the "business can't survive". Because this implies that if a company can't meet its debt obligations that it will cease operations. As long as operational cash flow is positive, then no amount of leverage or debt distress will halt the continued operations. The business might "fail" in the sense that the entity is legally re-structured and the equity owners, or even junior debt owners, are zeroed. But there's no reason in a country with well-developed bankruptcy law for this to have any impact on the employees, customers or operations of the business. The issue with coronavirus and failing businesses is that it's causing many businesses to have negative operational cash flow. In this sense the business may fail and the operations discontinued simply because revenue is no longer exceeding expenses. But if the operations are cash flow negative (and capital markets are unwilling to extend financing in the hope of future cash flow) then the business will fail regardless of its capital structure or leverage.
- Decathect 7y agoI'm really curious what your point is, since the willingness of capital markets to extend financing seems like it'd be very related to a company's capital structure and leverage. Like, were the businesses in question not over leveraged, they'd find it much easier to find the capital to continue operations during a downturn.
- dcolkitt 7y ago> extend financing seems like it'd be very related to a company's capital structure and leverage This seems intuitively appealing, but is misleading. The Nobel-prize winning work of the Modigliani-Miller Theorem[1] that a firm's capital or leverage ratio does not prima facie have any impact on its weighted-average cost of capital. [1] https://en.wikipedia.org/wiki/Modigliani–Miller_theorem https://en.wikipedia.org/wiki/Modigliani–Miller_theorem
- 7y ago