2007: What could cause the private equity bubble to burst?

AUDIENCE MEMBER: Good morning, Mr. Buffett and Mr. Munger. My name is Kevin Truitt (PH) from Chicago, Illinois.

Thank you both for, again, hosting this “Woodstock for Capitalists” for your shareholders and fellow capitalists. I have two questions. My first question is for both Mr. Buffett and Mr. Munger.

WARREN BUFFETT: I don’t like to interrupt you, but we’re only letting everybody do one question, so pick whichever one you feel the strongest about getting an answer for, please.

AUDIENCE MEMBER: OK. First, given the ocean of equity money that is out there — private equity money — that is out there today chasing deals, and with the quality of the deals continually diminishing as the quantity of good deals continues to go down, and given the fact that these private equity funds are getting their equity portion of the money from pension funds and college endowments and using very high levels of borrowed money from the banks, this has the look, feel, and smell of a bubble that is about to burst and is likely to end badly for many of the deal-makers and the investors.

What events, in your opinion, could cause this bubble to burst, and how do you think this is likely to all end?

WARREN BUFFETT: Well, as you were reading off that list, we are competing with those people, so I started to cry as you — (laughs) — explained the difficulty we have in finding things to buy.

The nature of the private equity activity is such that it really isn’t a bubble that bursts.

Because if you’re running a large private equity fund and you lock up $20 billion for five or longer years and you buy businesses which are not priced daily, as a practical matter, the plug will not — even if you do a poor job, it’s going to take many years before the score is put up on the score board, and it takes many years, in most cases, for people to get out of the private equity fund even if they wished to earlier.

So it does not — it’s not like a lot of leverage can lead to in-marketable securities or something there. And the investors can’t leave and the scorecard is lacking for a long time.

What will slow down the activity — or what could slow down the activity — is if yields on junk bonds became much higher than yields on high-grade bonds.

Right now the spread between yields on junk bonds and high-grade bonds is down to a very low level, and history has shown that periodically that spread widens quite dramatically.

That will slow down the deals, but it won’t cause the investors to get their money back.

There’s one other aspect, of course, that — of this frenzied activity, you might say, in private equity is that if you have a $20 billion fund and you’re getting a 2 percent fee on it or $400 million a year, which seems like chump change to those that are managing them but sounds like real money in Omaha — if you’re getting 400 million a year from that $20 billion fund, you can’t start another fund with a straight face until you get that money pretty well invested.

It’s very hard to go back to your investors and say, well, I’ve got 18 billion uninvested and I’d like you to give me money for another fund.

So there’s a great compulsion to invest very quickly because it’s the way to get another fund and another bunch of fees coming in.

And those are not competitors for businesses that Charlie and I are going to be particularly effective in competing with.

I mean, they — we are going to own anything we buy forever. The math has to make sense to us. We’re not given to optimistic assumptions, and we don’t get paid based on activity.

But I think it will be quite some time before — it’s likely to be quite some time — before disillusionment sets in and the money quits flowing to these people that are promoting these. And whether they can continue to make deals will depend on whether people will give them lots of financing at what I would regard as quite low rates.

Charlie?

CHARLIE MUNGER: Yeah. It can continue to go on a long time after you’re in a state of total revulsion.

WARREN BUFFETT: The voice of optimism has spoken. (Laughter.)