Most finance undergrads have heard that the ideal path is going from a top-tier investment bank to a top-tier private equity firm, making partner and then making tens of millions of dollars. Actually, undergrads only think about the first two steps – Morgan Stanley M&A à Blackstone Private Equity
They do not really have a step beyond that, but it is just another box to check after getting a good GPA in high school and then getting into a target college. People just love checking boxes.
However, how much “better” is private equity and where do hedge funds fall into the equation? For most people, money is a good proxy for how “good” a job is. So which job pays the most money?
As with most other questions, it depends.
Private Equity versus Investment Banking Compensation
For the most prestigious private equity shops such as Apollo or Blackstone, the rule was that they did pay a little bit better than investment banking – however you had to work just as hard if not harder. Additionally, the work is more mentally demanding because investment banking ultimately boils down to being able to run a process whereas private equity entails making an investment decision with someone else’s money.
However, this may not necessarily hold true anymore as investment banks want to present themselves as a career alternative instead of as a feeding ground for private equity firms. Bulge bracket investment banks, the famous ones that Main Street knows about, are looking to retain talent and change their image in a time when investment banking is less about advisory and more about providing a full service suite of capital markets solutions. In competing with private equity, elite boutique investment banks and Google or Facebook, they are getting more comfortable with raising salaries.
Elite boutiques have always offered a better compensation package in order to get the best and brightest staff. Does Apollo pay very well? Yes – but maybe not materially more than what an associate at Moelis & Co gets.
Pay, in terms of base salary is actually lower at most middle market firms. Bonuses are also lower than at investment banks – the equalizer is the carried interest component. Carried interest is the percentage of profits the general partner of the private equity fund gets after clearing a hurdle acceptable for investors which is calculated as an IRR.
So, for example, let’s say that the limited partners have access to all the returns their capital generated up to a 15% IRR. Afterwards, every incremental dollar may go 20 cents to the general partner and 80 cents to the limited partners. This also allows for PE firms to compensate their staff well.
At least in theory, this can be very attractive. Let’s say that a 1st year private equity associate at a 2nd tier large fund is promised a base salary of $150,000 + $75,000 bonus + $75,000 carried interest. $300,000 out the gate sounds great. Also, this is on par if not better than the investment banker.
However, the carried interest component is uncertain – you do not get it that year, and it is more of an expected value if things go well.
If the fund does badly, the realized gain may end up being not nearly as high. If the fund does very badly, you may get nothing as well as lose your job. The bonuses will be low too if the fund is not doing well – and there are a lot of variables outside of your control. This is an additional reason why elite private equity firms are coveted – an associate is with proven operators who will be able to get them the money that they are entering private equity for.
Carried interest takes a while to vest – so private equity professionals may find it difficult to leave because a huge chunk of their money may be forfeit. For better private equity firms, there is a similar structured up-and-out career trajectory like most investment banks. For smaller firms, this is not necessarily true and professionals can get “stuck”.
However, if you make it to the upper echelons of a fund and the fund does well, expect a private equity partner to make materially more than an investment banking partner/MD.
Hedge Funds versus Investment Banking Compensation
There is a new hedge fund starting up every day. The differences in hedge fund compensation are vast, so there is no easy answer to this. Also, the number of fund strategies is also vast – and they will pay differently as well. Someone joining Jane Street as a quant is not going to be a finance degree investment banker. They are going to make $300-$500,000 right out of school.
However, top funds that hire from major investment banks will generally offer a similar or slightly lower base for a switch over, but the variable compensation generally can be a lot higher. Hedge funds generally use the same compensation scheme as private equity funds – massively scalable and also immediate – whereas private equity takes time to delever and generate cash.
One of my friends left as a second year analyst in Europe when he was making 100,000 GBP a year (dating myself here) from the leveraged finance team of a bulge bracket. The next year at a hedge fund in Zurich he had a 400,000 GBP bonus.
On the converse, the lowest bonus you can get is zero + you’re fired.
Funds are looking for good idea generation and will pay for it. There is a lot of self-selection here, because the best analysts will usually go to the best funds, and the best funds are known to pay.
The pay also scales a lot faster at a hedge fund versus a private equity shop. You cannot really be a 29 year old private equity MD making $5 million a year. You can (not saying it is common) be a 29 year old hedge fund guy making $5 million a year. Companies take time to turn around and operate, getting your PM to put a large position into NFLX or SHOP does not. Getting a pension fund to give you a few hundred million dollars for a novel strategy that they do not understand can also be done at 29.
Despite all of this media nonsense about hedge funds, and for sure a lot of them are hacks with great marketing teams, hedge funds pay because they can outperform the market so much owing to very specialized knowledge and strategies.
I recently had dinner with a friend at a health care fund. Everyone has a health care background, did something like Harvard Business School + Bain + PHD Research. These guys read clinical trial data all day and more importantly they know what to do with it.
When the FDA decisions come out, these stocks go up by 50%, 100% or 300%. Remember Martin Shrekli? He managed to carve out tens of millions from his basement at a very young age.
Why Do Hedge Fund Partners Make More than Investment Banking Managing Directors
Ultimately for both alternative asset management classes, private equity and hedge fund partners who own a stake in the business or have a vested interest in its success will do a lot better than investment bankers.
This ultimately comes down to a function of scale and the risks and rewards of ownership.
The richest investment bankers have a limitation – their time. Even if they are the best in the world, they can only give so many clients advice at the same time.
Realize that being a managing director is already entrepreneurial in itself. You are leading a team and running a book of business. This franchise is supported by the capital markets capabilities of the bank you are working at. You are attending meetings put together by the grunts (analysts and associates).
The bankers that start their own elite boutiques essentially are running a team with many of these sub-investment banking pods. But the business is just not that scalable.
Hedge funds and private equity firms are leveraging other peoples’ money (as well as their own, to have some skin in the game). If they do well, this snowballs – one good project close or a good year in the markets means people are lining up to give you money. Herd behaviour.
The risks are also much larger – a bad year and subsequent withdrawals can kill you – and you do not have a future in finance after that.
Investment banking is different. After a good or bad year, you just move on with the same client base. Investment bankers are a necessary cog in the machine.