Every year third year business undergrads overhear that some of their peers are recruiting for investment banking. Investment banking probably has something to do with selling mutual funds at a bank, which is relatively better than being an unemployed millennial.
The students google “investment banking” and stumble upon Wall Street Oasis and decide that it has been their lifelong dream to join Goldman Sachs TMT/Morgan Stanley M&A/Elite Boutique Restructuring for the sole purpose of exiting to Blackstone/KKR/Silver Lake after two years.
The logic is that private equity is much better because the compensation is higher, the future compensation is much higher, the hours are shorter and the work is more interesting. Only work in investment banking for the exit opp!
If an investment banking analyst followed the above trajectory and joined a megafund private equity firm as outlined above, then the logic holds for the most part.1
However, 99% of people who work in private equity do not work at a megafund and whether private equity is a lucrative exit is ambiguous.
Private Equity Total Pay versus Investment Banking Total Pay
Here, we will divide compensation into 1) standard salary and variable compensation/bonus and 2) other factors such as carried interest.
Private Equity Salary versus Investment Banking Salary
In the United States, the country with the deepest capital markets, the megafunds consistently pay higher base salaries than the tier 1 investment banks outside of the elite boutiques (Evercore/Centerview/Moelis). However, reputable private equity firms that are not megafunds will tend to pay in line with bulge bracket investment banks or just slightly more or less. On this factor alone, there is not a real compensation difference.
For bonuses, this relationship holds. Similar to investment banks, there are many tiers of private equity below this. Technically, if you purchased a rental property with a lot of leverage you could consider yourself working in private equity. However, there tends to be a better alignment of tiers – so the conclusion is that basic compensation including bonus is not compelling as a standalone to exit.
Private Equity versus Investment Banking in Canada
In secondary markets such as Canada, private equity is much less compelling than banking in most cases. It is important to note that there is no megafund equivalent except for ONEX up north, which means that for the majority of bankers departing for private equity it means a sizable pay cut at a base salary and annual bonus level. The most coveted organizations to join in Canada include pension funds such as CPPIB and Ontario Teachers Pension Plan (OTPP) – base salaries here are around 15% less than domestic banks and 25% less than global banks. At lower tier firms, salaries can be literally 50% of equivalent banking titles with similar dynamics for bonus – a major 2nd tier pension fund and infrastructure fund both recently offered $90-100k with $15-25k bonus for an associate.
Taking this into consideration, private equity has to offer benefits that make the compensation consideration greater than or to at least match banking.
Carried interest is the most exciting part of private equity. The idea is that private equity general partners get to participate in the profits of invested capital beyond a pro-rata level. In practice, after a certain return has been met (the hurdle rate), the private equity firm will take a success fee that is a percentage of the gains to the fund. The industry standard is 20% participation on profits.
In the US, carried interest is taxed at the capital gains rate instead of at the general corporate rate – effectively half, making private equity a far more lucrative business than it would be otherwise.
Now while this is enticing from a private equity firm standpoint and explains why they can compensate employees handsomely, the next question is whether new private equity associates or analysts will reap the benefits of this carried interest. At most private equity firms, the answer is no – carry is usually not granted until the senior associate or VP years at very large funds. Usually for smaller funds, only partners get carry – there is no reason to pay any more because there is an oversupply of willing workers while the deals are much less sophisticated.
Accordingly, for carry to be a consideration for the exit, there has to be confidence that surviving well after a VP title has been earned is achievable. Successful PE employees have similar skillsets to successful bankers, with the exception that they have to be more engaged intellectually as there is an investment decision instead of mastering a process – so anyone who thinks that they will cut it in PE when they cannot play the politics in banking is in for a rough surprise.
Let us assume that you receive carry as part of your compensation – what does this mean from a numerical standpoint?
Carry only starts to influence the onboarding decision at large funds. With a $1 billion dollar fund with 1x return on invested capital, the profit is 1 billion dollars (assuming that hurdles). Of that $1BN, 20% is carry. Of that 200 million, what are you contracted for? If carry is 0.5%, that is $1 million dollars – nothing to sneeze at but over the life of the fund (possibly over 10 years), this may not be serious consideration. At smaller funds, you can discount it completely from your employment decision.
Now for employees who are confident that they can make it to the top at a PE fund, carried interest will definitely swing the advantage over to private equity – although it is paid over time.
Co-Investing in Funds… With Leverage
Private equity firms may let employees invest in their funds. Some firms force their employees to invest in their funds. For reputable private equity firms with a number of successful funds, this means a consistent return every year on invested capital. For a new fund, this is a far riskier and less valuable proposition.
Although less obvious over the last five years as the stock market has had a strong bull run, recall that the S&P has averaged high single digits throughout its history but with substantial volatility. A good private equity fund will consistently outperform the market while generating fairly stable returns – however, there is a J-curve where money is heavily invested first and takes time before it begins to yield profits.
At some firms, employees can leverage their returns using company loans arranged through banks that can juice up returns even further. This is risky, however, if a fund does not work out as planned (at a smaller fund, this is a real consideration).
At a fund like CPPIB where employees can coinvest with the general fund, this is a valuable perquisite especially when asset prices are high – such as the stock market right now. This is because there are a number of instruments that CPPIB and other pensions can invest in that are not available to individual investors and because they do not have the same tax implications as other institutional investors as they are government. This means a strong and steady return every year.
Other Benefits to Consider in Choosing a Job
Banks are generous benefit providers from orthodontics to vision to massages to sports games and client dinners. Megafund private equity firms will spare nothing to attract the best talent. In this aspect, they are mostly equivalent. Banks will have employee share purchase programs that can stack up over time.
What becomes a differentiating factor is a unique compensation scheme such as a defined benefit pension. Most banks have moved to defined contribution payments as it takes liabilities off of their books. OTPP allows employees to participate in the robust teacher’s pension. This is a major compensation consideration.
Better Hours and Lifestyle in Private Equity
This is false. Private equity hours are variable by fund, as are investment banking hours. Both are bad and for most private equity firms it is not enough to justify the compensation stalling. However, private equity is not client dependent (the PE firm is the client, although partners have to schmooze limited partners) so they do not have to respond on a whim to requests. As such, the hours are not better but are usually better delineated throughout the week so that scheduling personal affairs is less stressful.
The stress is arguably a lot worse in PE because there is a profit and loss number which depends on good decision making. Investment banking is fine as long as you can run a process that you have run many times before.
More Interesting Work in Private Equity
Investment banking is about running a process and making a sale. The more sophisticated the client, the more intellectually rigorous the job – as such top tier advisory firms such as the elite boutiques and some bulge brackets will demand a very sound understanding of capital. Regardless, the sell side exists to sell and there is no money at risk nor is there an investment decision (ignoring funding the financing via a loan).
Private equity is about the investment decision – and at a junior level, supporting the investment decision making process. In this aspect, if someone likes investing and is more cerebral, it could make sense that private equity is an appropriate exit.
The reality for 99% of people who want to move into private equity, however, is that they have read half of an article about it and think that “LBOs are cool”. If you have not done ample self study pertaining to investing prior to reading this article, you cannot make a case for wanting to move into private equity. If you cannot build a model that generates an IRR from scratch, same thing.
So is it the dream? It depends. But usually no.
An interesting tidbit, a material portion of our traffic is from people looking for investment banking exit opportunities and these people are in college. Mayhap thinking too far ahead.
- Megafund private equity shops (and top tier hedge funds) are known to work their junior staff much harder than sweatshop groups at Tier 1 Bulge Bracket investment banks. A recent conversation with a peer at a Tier 1distressed debt outfit on the West Coast was telling us about how their boss was teaching them to work during car rides to prospective investments and washroom breaks so that they could work for 100% of the time and make more money.