All the gear, no idea?

In my last post, I discussed the sources of private equity’s outperformance over listed equities but left out one controversial factor: leverage. Warren Buffett has been vocal in his criticism of private equity performance reporting, arguing that the use of leverage— which adds financial risk—artificially inflates returns. This raises an important question: should private equity returns be reported on an ungeared basis to give a fair, risk-adjusted comparison with other asset classes?

Warren, you’re the GOAT, but I have to disagree on this point. Yes, the average investor or mutual fund can’t borrow money from a bank to buy stocks. But that doesn’t mean the companies in their portfolio aren’t using debt to optimise their capital structures. Similarly, in a leveraged buyout (LBO), private equity firms don’t borrow at the fund level to boost returns. Instead, portfolio companies gear their own balance sheets to maximise risk-adjusted returns on capital. Even Berkshire Hathaway, between 2019 and 2023, operated with an average leverage ratio of 1.6x. This particular statistic means about 40% of its assets were financed with debt.

Buffett’s critique might have applied during the junk bond era when corporate raiders used eye-watering levels of debt in their takeovers, but today’s landscape looks markedly different. Consider this statistic: syndicated LBO loan issuance in 2023 declined by about 56% from 2022 and is even lower than in 2012—despite the fact that the total value of deals today is nearly double. Sure, private credit has filled the gap to some extent, but there is growing sentiment among investors that the traditional LBO has "lost the L." Several factors are driving this shift:

First, and most obvious, is that lenders have become nervous. Despite the claim that they’re "open for business," banks have tightened their purse strings following Russia’s invasion of Ukraine, amid rising interest rates and growing recession fears.

Second, and more systemic, is that the industry is shifting toward underwriting more “growth-type assets”, and? the optimal capital structure for LBOs is evolving. Historically, LBOs targeted mature, cash-generative juggernauts, typically financed with 50-60% debt (KKR’s infamous takeover of RJR Nabisco in the 80s was 87% debt-financed!). Today, however, a software acquisition might only have a loan-to-value ratio of 25%. Why? Growth demands reinvestment —working capital, capex, R&D, and people—leaving less free cash flow available for debt service.

Third, and perhaps underappreciated, is the sheer amount of dry powder available. According to Bain, buy-out funds are sitting on around $1.2 trillion in committed but undeployed capital. Here’s why this matters: debt only makes sense in a constrained portfolio context. If you have R500 million in a fund but your investable universe is R1 billion, you might use debt to bridge the gap and enhance returns. But when demand for deals exceeds supply, taking on debt becomes less appealing: fund mandates typically require that unallocated equity sit in cash or equivalents if suitable private assets aren't available.

Think of it like this: if you have enough cash to buy a house outright, you might still opt for a mortgage and invest your extra cash elsewhere—perhaps in another property or stocks. But if the only option is to park the cash in a money-market account, it makes little sense to borrow and incur a negative carry.?Similarly, in absence of attractive alternatives, funds are deploying more equity into "birds in the hand".

So, how does this all stack up?

1. Lower Leverage = Lower Risk:? Lower leverage takes the strain off businesses and gives them a higher chance of survival during turbulent times. It also shifts risk to investors who are better equipped to understand and manage it. In highly leveraged scenarios, banks bear much of the financial risk, which ultimately falls on depositors—regular citizens. With less leverage, more risk is borne by the fund’s LPs, typically high-net-worth individuals, university endowments, and the like—parties better able to bear financial risks.

2. Better Allocation of Capital: Investing in growth assets is better for the economy as a whole than merely transferring wealth from private equity firms to retiring shareholders. Growing companies need investment, and this focus on reinvestment drives long-term value creation, rather than short-term financial engineering.

3. Temporary Imbalance, Long-Term Opportunity: In the short term, the deal supply deficit will bid up asset prices and compress returns. However, I believe we will see more companies entering the private market over time. The number of listed companies in both the U.S. has and South Africa has nearly halved in the past 20 years, reflecting a broader global trend toward private ownership as companies shun regulatory burden and seek more flexibility. Even more structurally significant?is the impending retirement of the wealthiest generation in history—the baby boomers—which is expected to transfer around $14 trillion in business value over the next five years. That's 12x the amount of dry powder available.

Archimedes famously said, "Give me a lever long enough and a place to stand, and I will move the world." Smart Greek, that. In today’s private equity environment, the lever provided by banks is getting shorter, and the place to stand is shifting from mature cash cows to riskier growth assets. But the world of deal opportunities may be on the cusp of a multi-trillion-dollar windfall.

So Warren, maybe you should just leave private equity a loan.