How different is private equity from Berkshire Hathaway? The phrase “private equity” has a certain ring to it, suggesting providing shareholder capital to buy and hold businesses. In fact, most private equity firms use substantial debt to acquire companies, charge considerable fees to restructure them, and finally flip them as rapidly as possible, often to public capital markets.
Berkshire’s approach is essentially the opposite, and sounds more like what the phrase private equity connotes: regularly buying companies using solely its own capital, which includes leverage from insurance float but never debt, and holding subsidiaries permanently while giving managers free autonomy rather than costly advice.
Buffett has been criticizing private equity for decades, sometimes as a means of differentiating what Berkshire offers potential sellers of businesses compared to what private equity delivers. Consider this 2008 passage (p. 220 of The Essays of Warren Buffett: Lessons for Corporate America):
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.
Private equity participants scoff. In interviews for a book I am researching comparing Berkshire with private equity, executives wonder what is really so different between them and Berkshire. Some seem dismayed that Buffett receives adulation while their own industry draws rebuke. For example, George Baker and George David Smith, wrote in The New Financial Capitalists: Kohlberg Kravis Roberts and the Creation of Corporate Value (p. 29):
Warren Buffett earned a measure of popular respect by taking control of undermanaged assets and improving them. . . . The fact that management buyouts achieved much the same kind of result was lost on most people.
In truth, as my research and a related seminar I’m teaching show, private equity is a diverse industry with a wide range of styles, strategies, and results. True, leverage is a common source of acquisition financing, but sometimes no greater than that used by corporate buyers in strategic acquisitions. Likewise, while private equity firms all tend to charge 2-percent of fund size plus 20-percent of returns over a hurdle rate, they vary in their extent of additional lucrative advisory and management fees. Firms also differ in the use of financial engineering—and related fees—such as arranging for dividend recaps (using debt to fund cash distributions to shareholders) and asset stripping transactions (such as sale-leasebacks to monetize the value of improved real property).
I am working on a project to classify private equity firms along vectors defined by such attributes as scale of leverage, depth of intervention, size of fees, degree of financial engineering, risk of insolvency, length of time horizon, level of outside investor returns, and relative effects on constituencies such as labor. Examined this way, on each dimension, Berkshire is at one extreme and well-known private equity firms reside along a continuum, with a few of the most prominent industry leaders at the other pole, the opposite of Berkshire.
On that scale, Berkshire exhibits the following traits: no acquisition debt, virtually no intervention, no advisory or other fees or financial engineering, permanent time horizon (never having sold a subsidiary in forty years), verifiable investor returns exceeding a 20% compound annual growth rate for decades, few subsidiaries ever at risk of insolvency, and generally positive effects on non-shareholder constituents.
In contrast, the more famous private equity firms, including KKR, use considerable acquisition leverage; routinely redirect strategy, often installing new management; charge substantial advisory fees; engage in extensive financial engineering; sell companies as soon as possible as dictated by the fixed life of related partnership funds; promise outsized investor returns but make these hard to verify; often run portfolio companies into insolvency; and frequently squeeze savings through reductions in headcount or payroll.
Despite the existence of many reputable private equity firms measured in these terms—those avoiding excessive leverage, preferring operational improvements to financial engineering, steering clear of bankruptcies that erase employee benefits—the prominent actions of some visible players impair the industry’s reputation. And despite the numerous problematic tactics, the most pernicious and publicized problem are fees. After all, outsized and opaque fees create the incentives that stimulate the other excesses.
Hot on the trail are journalists such as Gretchen Morgenson of the New York Times, who has written often about the industry’s hidden and excessive fees and Elliot Smith of MarketWatch, who offered this good rundown earlier this week; regulators such as the Securities and Exchange Commission, which has settled two high-visibility fee actions against Blackstone and KKR; and scholars such as Kathryn Judge of Columbia University, who recently published a paper exploring excessive fees of financial intermediaries generally, on which I contributed a solicited comment enlarging the examples to include private equity.
Expect the rising sunlight on private equity fees to strengthen the competitive pressure that a rival like Berkshire exerts. Some private equity firms may respond by curtailing fees, cutting excesses, and elongating time horizons. Stressing Berkshire as an alternative to private equity may multiply the number of acquisition entrepreneurs who emulate the conglomerate. While it is unlikely—and would be unappealing—for everyone to be like Berkshire, more buyers following its practices would do the buyout industry some good. And that would help the rest of corporate America too.
The preceding post comes to us from Lawrence A. Cunningham, professor at George Washington University and author, most recently, of Berkshire Beyond Buffett: The Enduring Value of Values. The post is based on his recent article, entitled “Berkshire versus KKR: Intermediary Influence and Competition” and available here.