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Why Private Equity Rubs Warren Buffett the Wrong Way

Private equity firms have been the topic du jour for some time now, with the current interest fueled by the increased public scrutiny flowing out of Mitt Romney's campaign for President. The

Private equity firms have been the topic du jour for some time now, with the current interest fueled by the increased public scrutiny flowing out of Mitt Romney’s campaign for President. The Oracle of Omaha, Berkshire Hathaway’s (BRK.A) Warren Buffett, threw his own hat into the ring recently with an interview in Time Magazine where he bashes private equity firms for their exorbitant fees and for leaving some of the companies they buy ill prepared to move forward.

“I don’t like what private equity firms do in  terms of taking every dime they can and leveraging [companies] up so that they really aren’t equipped, in some cases, for the future,” said Buffett in the interview.

Buffett has long been known for making shrewd, long-term bets on fundamentally sound companies, so it may come as no surprise that private equity’s strategy of buying up companies in hopes of revamping them for short-term profits doesn’t sit well with Buffett. But Buffett also lambasts the private equity crowd for their fee structure, joining partner Charlie Munger in calling private equity firms The Two and Twenty Crowd in reference to the 2 percent management fees and 20 percent carried interest they charge.

“A number of these acquirees are now in mortal danger because of the debt piled on them by their private-equity buyers,” Buffett wrote in a letter to shareholders just last year. “It’s a lopsided system whereby 2 percent of your principal is paid each year to the manager(ie. Bain  Capital) even if he accomplishes nothing– or, for that matter, loses you a bundle– and additionally 20% of your profit is paid to him if he succeeds.”

In that same letter, Buffett bemoaned the change in name from “leveraged buyout operators” to “Private Equity Firms,” calling the move “Orwellian” and saying that the new name didn’t fit because it “turns 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.”

Pitched Debate Spills into Political Arena

The entire question of what role private equity plays in the economy has become muddled, that tends to be what happens when any subject enters the political arena. Newt Gingrich and Rick Perry certainly seem to think that Private Equity isn’t helping America, but then it’s hard to say whether or not they would have said the same thing prior to Mitt Romney becoming the front-runner in the Republican Primary. While many prominent voices, like Buffett, have expressed significant disdain towards private equity’s practice of buying up companies and reshaping them into profitable entities, others have come to the defense of private equity.

Paul S. Levy, manager of the modestly-sized $4 billion fund JLL Partners which he co-founded in 1988, talked with Andrew Ross Sorkin of the New York Times about the nature of his industry, insisting that while tough cuts are sometimes required, the overall goal of Private Equity is to improve companies.

“We want to build businesses,” Mr. Levy told Sorkin. “Nobody wants to fire people. We want to retain all of the value-added, high-quality people that work at these companies. But it’s like any other endeavor. If there are more people there to make the shoes than needed, you can’t keep the people. It’s not about wanting to get rid of people. It’s about wanting to make the company operate on a size and scale that’s commensurate with its opportunities and its revenues such that it can make profits and then build the business. It’s as simple as that.” He added that “Not everybody is perfect; we’ve had our mistakes as well, but I don’t think there’s a predatory attitude in doing these deals.”

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