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Warren Buffett Frowns On Private Equity Performance

Tom Burroughes, Group Editor , May 6, 2019

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The world's arguably most famous investor is uneasy about private equity, an asset class that has drawn billions of dollars of inflows from wealth managers and other parties in recent years.

Renowned billionaire investor Warren Buffett has turned his fire on the world’s private equity industry, a sector he claims inflates performance.

Already a critic of hedge funds, the Omaha-based investor argues that private equity funds, which haven’t attracted some of the same fee compression as hedge funds, aren’t behaving themselves.

With more than $1.0 trillion of un-deployed capital, aka “dry powder” in the jargon of the sector, private equity has boomed, drawing inflows from wealth managers, family offices, pension funds and endowments. (Across all forms of private capital, the figure is over $2.0 trillion, according to Preqin, the research group.) Low yields on conventional listed equities and bonds, caused by ultra-low central bank interest rates, have encouraged investors to tolerate the lower liquidity of private markets in return for higher yields. Some wealth management industry figures have told Family Wealth Report that the flood of money into private equity represents a potential fracture point for the US and wider economy. However, it is also argued that private equity as a share of the total economy is not so large as to be a major problem.

Buffett was quoted by Bloomberg and other media as saying at his firm Berkshire Hathaway’s annual meeting: “We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest. If I were running a pension fund, I would be very careful about what was being offered to me.”

Buffett and Berkshire Vice Chairman Charles Munger criticized how some private equity firms portray performance. Firms will include money that’s sitting in Treasury bills waiting to be deployed when charging management fees, but will exclude it when calculating a so-called internal rate of return, the performance measure in which most funds are judged, Buffett said.

“It makes their return look better if you sit there a long time in Treasury bills,” Buffett said. “It’s not as good as it looks,” he said. 

In February 2017 Buffett told shareholders in his annual letter – often closely read by the media and investors – saying that managers haven’t justified fees gleaned over almost a decade of “dismal” returns. Investors would be better served by holding index funds instead, Buffett said in that letter. His comments fueled debate about the extent to which investors should pay high fees to capture market-beating “Alpha” in efficient markets. 

His latest criticism of private equity also includes the claim that private equity’s use of leverage – which can be risky – boosts the asset class’s results. Known for his value-based investing philosophy, preference for sometimes traditional sectors and skeptical of tech stocks during the dotcom boom, Buffett’s views are treated with respect in an industry not always known for its adulation of high-profile money managers.

Besides private equity, recent years have seen a buzz within wealth management over private debt, real estate and infrastructure. Tighter international bank capital rules under the “Basel” system and regulatory changes have squeezed conventional bank lending to firms, with non-bank sources of credit seeking to plug the gap.

There have been some warning signs. A few weeks ago Preqin said that 72 per cent of investors and 62 per cent of fund managers it tracked said that high asset pricing as a key concern in 2019, making it the biggest issue cited by either group. While distributions have remained high, capital calls have accelerated, it said. The net flow of capital to investors fell from $150 billioni in 2016 to -$5 billion in 2017 – the first negative flow since 2010.

It has been easy to see the asset class's appeal, although the lower liquidity has to be factored in. In the 10 years to June 2018, the private equity industry has outperformed the S&P 500 index, returning 10.8 per cent compared to 10.2 per cent for the public market index. Some 90 per cent of investors report that their private equity investments have met or exceeded their expectations in the past 12 months, Preqin said.

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