By Tom Bradley

Warren Buffett’s 2008 Letter to the Shareholders of Berkshire Hathaway was published on Saturday.  As usual, it brings a refreshing perspective on topics of current interest.  Over the course of the week, we’ll highlight a few. 

As he does every year, Warren talked about how Berkshire Hathaway is a preferred buyer for companies that want to sell.  That’s because they leave existing management in place, give them the independence and support to continue growing, don’t burden them with debt, and importantly, have a long time horizon.  (Berkshire has no deadline for which they need to monetize an investment by ‘re-selling’ it or taking it public.  The preferred time frame is ‘forever’.)

When companies or assets become available, the other potential bidders are often financial buyers - ‘private equity’ funds or merchant bankers.  Like Berkshire, they too want the business to grow, but they go about it the opposite way.  Warren explains:

“Some years back our competitors were known as 'leveraged-buyout operators.'  But LBO became a bad name.  So in Orwellian fashion, the buyout firms decided to change their moniker. What they did not change, though, were the essential ingredients of their previous operations, including their cherished fee structures and love of leverage.

Their new label became “private equity,” a name that turns the 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.  A number of these acquirees, purchased only two to three years ago, are now in mortal danger because of the debt piled on them by their private-equity buyers.  Much of the bank debt is selling below 70¢ on the dollar, and the public debt has taken a far greater beating.  The private equity firms, it should be noted, are not rushing in to inject the equity their wards now desperately need.  Instead, they’re keeping their remaining funds very private.”

On his last point, we should not expect private equity firms to act otherwise.  In these distressed situations, they have assuredly lost what little equity they invested in the deal.  So to put more money in (good money after bad?) would require that the already generous lenders take a haircut too and reduce the company’s debt.  It’s only logical that before more equity capital goes in, the entity has to be worth at least as much as the debt outstanding. 

In some instances there may be an equity injection (after extensive restructuring negotiations), but in many others the owner will simply hand the keys to the bondholders and walk away.

We have an all-too-familiar example of this playing out in Canada right now.  Air Canada, which is on the brink of bankruptcy, is 75% owned by ACE Aviation Holdings.  ACE is the holding company that resulted from a previous restructuring that was driven and supported by private equity interests.  When ACE spun off part of the airline to public investors, it sent all the debt with it.  So while ACE is floating in cash after selling its other businesses (including Aeroplan and Jazz) and the shareholders are quarrelling about how it is going to be paid out, the original foundation of the company is dying on the vine, unsupported by its owner.

It’s too bad for Canadian flyers, airline employees and bondholders that Air Canada is not the type of business that Berkshire Hathaway would ever invest in.