At yesterday’s Berkshire Hathaway annual shareholders’
meeting, Warren Buffett took another swipe at private equity fund managers.  “If I were running a pension fund,” he said,
“I would be very careful about what was being offered to me.”

Buffett has taken shots at the private equity sector for
many years, targeting the industry’s aggressive use of leverage, opaque
reporting and questionable returns.  As a
former private equity fund manager, I don’t agree with everything Mr. Buffett says,
but there have been times when his criticisms have been well-founded,
particularly when the practices of some of the larger funds have been driven
more by self-interest than maximising returns for their investors.  Right now, I believe we are witnessing
another such moment.  In my view, the
recent drift towards “super carry” is a step too far.

For decades, the industry ran on a “two and twenty” pricing
model.  Fund managers charged an annual management
fee of 2% of committed capital plus 20% of profits made for investors (known as
carried interest).  However, over the
last year or so, a handful of mega-fund managers have raised their carried
interest to 30%, and there is talk of more to come.

It’s not difficult to see why.  The last few years have seen record inflows
of capital into the sector, with a disproportionate amount going into the
coffers of the mega-funds.  Pension funds
and other institutional investors continue to see private equity as a route to
out-performing the quoted markets and have voted with their feet, ploughing
some $750 billion into the sector in 2017 alone.  Faced with such massive demand for their
product, who can blame some managers for raising prices?  That’s capitalism at work, right?

The problem is the record returns reported over the last
couple of years are not necessarily indicative of future results.  You see, private equity is one of the most
cyclical games in town.  Recent realised
profits reflect investments made in the early part of this decade, when
acquisition multiples were low following the financial crisis.  Right now, in my view, private company price
multiples are at their peak.  According
to McKinsey, 2017 saw the global private equity average deal size rise by 25%
and most of this was as a result of multiple increases.  In other words, in order to deploy record
amounts of dry powder, fund managers are having to pay handsomely for their
targets.  When recent investments are
divested in five or six-years’ time, my worry is that we will be facing a completely
different stage of the cycle.

If I’m right about prices having peaked, then future profits
for investors will be considerably lower when current funds reach maturity.  Worse still, investors in those mega-funds
with 30% super carry will feel particularly aggrieved.  Not only will their profits be lower, but
they will also have paid their private equity managers much more for the
privilege.

If more managers follow suit and introduce super carry into
their funds, I believe institutional investors will look to do what some of
their more forward-looking peers have done already.  They will build their own in-house deal teams
and start cutting out the expensive middle-men.

The rise of super carry means private equity managers run the risk of cutting their own throats.