Buffett explains private equity

As I read this excerpt from Warren Buffett's annual letter to shareholders, all I could think of was the private equity acquisition of the Caritas Christi health care system.  As I have noted, this transaction will have a tail that will leave Massachusetts policy-makers with difficult choices.  Just think of the implications of a hospital system being considered "a piece of merchandise."  What plans are being made now to protect the provision of essential health care services in several Massachusetts communities?

When owners wish to cash out entirely, they usually consider one of two paths.  [A competitor or] the Wall Street buyer. 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 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.