I compiled this post because I've received several questions aroud this topic in private messages and I thought it may be helpful to discuss my experience with a wider audience. I would like to caveat all of the information in this really long post below by saying that these are all broad generalizations based 100% on my own experience. Please don't try to defend how your respective funds are different - if they are, that's awesome and more power to you. This is just a compilation of thoughts based on MY experience. I know this doesn't apply to everyone and I'm not pretending it does!
1) What I liked most about PE
Working with the management teams. It sounds cliche to say it, but it really is true. They were all incredibly hardworking intelligent people who knew their industries and competitors cold and it was an incredible learning experience working with them to figure out different avenues for future growth for them. As bankers/consultants/PE folks, we take for granted how difficult it is to run a business day-to-day and I got to observe that first hand. We helped mgmt out with creating monthly dashboards, budgets, maintaining KPIs that could help them measure the performance of their businesses better, and very importantly, we helped them scale inorganically via M&A and led all negotiations on their behalf.
2) What made me leave? Many reasons:
a) Lifestyle: After working in bulge bracket investment banking and two different middle-market PE funds, I realized that the lifestyle in a transaction driven environment was just never going to get better -- atleast not until I made MD/Partner which seemed many eons away. I worked an average of 100 hrs/week in IBD and a solid 80-90 hrs/week in PE (and mind you, the PE funds I worked at were NOT the likes of Carlyle/KKR- they're solid firms, but they do operate in the middle-market). PE can also be an extremely hierarchical environment and tenure matters. I couldn't see myself spending a decade more in this career with my lifestyle driven by the transactions I was going to work on. I was rated top bucket in both IBD as well as at either PE fund so I don't think it was a question of not being efficient. And frankly, I really liked the people I worked with in both careers -- I fortunately didn't have to deal with too many a'holes. So it wasn't a people or performance thing, but a lifestyle driven decision.
b) Drifting focus from investing: I realized that as folks around me in PE got promoted, they were being rewarded and valued more for activities that didn't excite me at all. While being active on a deal, they were valued for running a tight deal process and managing multiple stakeholders (lenders, accountants, consultants, sell-side, target mgmt team, lawyers) rather than thinking critically through the investment thesis itself. Prior to deals closing, my senior deal team members also spent an inordinate amount of time thinking through topics like board makeup and general governance, deal structuring/ thinking through the capital structure and how to exploit it, management compensation, purchase/merger/employment agreements, coming up with lists of add-on prospects etc. All of this is critical to do and by the way makes or breaks deals; it just didn't frankly excite me very much. I don't want to understate how difficult this is to do -- very few people have the raw intelligence/ charisma/ horsepower to do this well, and those who stay get compensated well for it. Just wasn't for me.
c) Impact of fund lifecycle on decision making: PE funds are typically structured with a 10 yr life w/ 2 1-yr extensions, and an annual hurdle rate that can be in the 6-8% range. The general logic is invest for the first 5 yrs, and harvest for the next 5. Once you're 70-75% deployed, you can begin to raise the next fund. For many reasons including the hurdle rate, the need to return capital in 12 yrs (10+2), fundraising for future funds, IRR returns, etc. -- PE firms have to deploy rather quickly and then begin to return capital ASAP through dividends, recapitalizations, sales etc. In general, I've observed firms be extremely disciplined around their investment criteria in the first couple yrs of the fund, which is a rational/conservative approach, but more often than not, they find themselves scrambling and under immense pressure to get a deal done in the next 3-4 yrs as it becomes difficult otherwise to go out and raise their next fund. This "pressure" encourages irrational/silly risk taking towards the 4th or 5th yr of a fund where all discipline goes out of the window as folks are under pressure to deploy capital. This is especially true if the fund's first couple investments appear to be doing well and people begin to relax their standards in order to get a deal done. PE has gotten insanely competitive over the past decade, and it is no secret that competition and the level of dry powder in the industry has pushed valuations up. What further compounds the problem is this pressure to get a deal done due to the constrained life of the fund. Evergreen funds/family offices without a defined fund life thus have a significant competitive advantage over traditional PE funds in this regard.
In addition to the fund's life driving at times irrational deal making, it also creates a misalignment between management teams and funds. Many times, I've been in conversations where we readily sacrificed investments that would be beneficial to the long-term growth prospects of the business in order to showcase high profitability (EBITDA/EBIT/FCF margins and conversion) at the time of sale. If I'm a PE fund trying to maximize my IRR/MOIC at exit, I'm heavily incented to sacrifice LT performance in order to juice up EBITDA and maximize FCF conversion so the next guy who looks at it pays a higher multiple because he can lever up the business even more.
d) The compensation structure: As much as I liked the people and the work itself, let's face it - the comp is at least a small driver behind why people work in finance, whether on the sell-side or buy-side. There is no question that finance in general pays well, but carried interest accrues heavily to senior management at most firms, and is generally paid out post a realization i.e. when you sell a business. Even if you're willing to wait for a sale (aren't we all long-term here anyway :)) to receive a distribution, many funds will claw back any distributions to the investment team to ensure they're meeting their LP hurdle rate (typically 8%) and/or it will be strongly encouraged for you to roll that distribution you've just received into the next fund the firm is planning to raise. The base and bonus by itself is attractive- there's no question about that. But for those who think they're going to become millionaires overnight with their carried interest, you can forget about it for some time. This is by the way also why folks at PE funds have such long tenure - carried interest can be locked away for some time and it can be multiple yrs of grinding it out before you really start to see some $. Every firm is different but in general this issue never really resolves itself -- the guy who is MD/Partner at xx PE fund now probably worked his way for over a decade to earn that carry and he's going to give you, Mr Associate or VP, as little of that carry as possible unless you "earn your stripes".
Another issue with why the compensation structure works the way it does is deal attribution. Everyone wants to take credit for a good deal and share in the economics, and no one wants to associate themselves with a bad deal. But because deal teams can involve multiple senior level folks (e.g. an investment partner, an operating partner, a principal, etc), deal attribution becomes hard to figure out. Many PE funds wrestle with this problem even though people may not readily admit it.
e) Lack of liquidity: PE is great if company performance is fine and it does well over 2-3 yrs even if there are quarterly bumps down the road (the public markets are overly punitive for cos. missing qtrly #s- it sucks but it is what it is). However, if things are not going so well, the lack of liquidity can really hurt you in PE and you often have to wait an entire cycle for performance to rebound (if it does). It is not as easy to just write off a small loss and walk away selling some shares off. You still have to run through the banker song-and-dance and court strategics/PEs and explain why performance hasn't been great. You take a significant hit on the #s of course but also on the purchase multiple and a couple bad deals can be reputation damaging with the banker community. The level of psychological/emotional drain that an underperforming investment can result in for a PE investor is not immaterial.
3) What I like about the HF space
I'm currently at a highly concentrated long biased HF and I cannot disclose any further information without compromising my identity. An easy way to answer this question is giving you the reverse answer for why I left PE. My lifestyle changed significantly (8.30-6) and limited/no weekend work -- every PM and fund is different and I've heard nightmares on the HF side. It's generally all PM driven and my PM happens to be one of those guys that values life and family too much to be impacted by market gyrations (a factor could be that he's been at this for a long time and already done well enough for himself). 100% of my focus is now on investing vs dealing with 3rd parties. The level of autonomy I'm afforded is great (I work on my own ideas 100% of the time) and so I structure my own schedule for the most part. I also genuinely believe I'm compensated to think now critically about an investment vs be a process driver. Compensation is better than either of my prior funds, and I finally have skin in the game (even if it's little, it actually makes me care about the investments I'm pitching and the performance of the portfolio). To be 100% honest with folks on this forum, while I can't complain about the compensation or the autonomy of our structure, what mattered most to me was lifestyle as I wanted to work on my health, pursue other fitness/non fitness related passions outside work and be able to spend time with people I love including my significant other, my friends etc. I think I was able to achive this. My quality of life has dramatically improved, and I don't think I would jump to a different fund even if they were paying me 2-3x of what I currently make -- life's too short and I've seen too many of my family members pass away prematurely for me to prioritize the $. That's just me - different folks/different strokes.
4) What I dislike about the HF space
a) Quality of Level of Due Diligence: One of the biggest eye-openers to me (and I think to many of my PE brethren) has been the shoddy quality of due diligence people at "respected funds" perform before acquiring large positions which can be in the hundreds of millions. Let's just say I respect far fewer public market investors than I did before I made the transition! There are many legends talked about in the press who I've learned unfortunately rely on others to do all the dirty, deep work for them and invest on "tips" (even though they'll spin BS to you making it sound like they've done a lot of work when they really haven't). The barriers to entry in the HF world are limited (truly anyone with a few hundred thousand $ can set one up) and there are a LOT of people who have NO idea what they're doing with LP money. I'm actually amazed at how these folks attract capital to begin with. There's many more fakers than legitimate fundamentals focused investors who truly do deep, PE styled high quality diligence. Many say it, but few truly do it. That's arguably my biggest source of frustration.
b) Transactional Nature of Relationships: Another source of frustration is the transactional nature of (almost) every meeting with management teams. Even if you own 2-3% of a business, it's hard to get more than a few hours of management time a quarter. And even when you get it and have the opportunity to ask difficult/detailed questions, what you generally receive is a canned set of BS responses that they give every investor (google Reg D- any information disseminated by the team to you has to be made available to every public market participant). Mgmt teams are very hesitant to answer questions beyond a certain level of detail and underperforming management teams frequently abuse/hide behind Reg D in order to not have to disclose additional information behind problem areas within their business.
c) The daily/monthly/quarterly scorecard: This affects me less now than when I started but the fact of the matter is it's an HF and your public positions are all marked-to-market everyday and you get paid based on where your fund shakes out on Dec 31. When a position is working against you for reasons you cannot seem to understand and articulate to your team, it can be incredibly frustrating and demoralizing.
d) The "edge" concept: Frankly I think very few people have it. Everyone and their mom talks about the three sources of edge/alpha (information, analytical, behavioral). Google these - I'm not going to explain it here as this post is already incredibly long. People often talk about "time arbitrage" as an edge. I'm just going to call all of this out as complete and utter BS. Most funds are simply copy cats with similar investment criteria, talk to the same "expert networks"/Gartner etc, attend the same user/customer conferences, are fed the same BS by the management teams, talk to the same competitors when analyzing an investment, talk to the same sell-side folks. I would like to think I'm god's gift to the world of public fundamentals focused investing and my research and modeling is super differentiated, but at the end of the day, it's really not. I've just accepted that and think humility in accepting that fact is not a bad way to operate in this world. Based on my experience, I've also come to the conclusion that it's better to pick a horse in a decent, growing industry where everyone wins vs one where I think my superior analytical skills will lead me to the one diamond in a shitty industry. I'm just not that smart. It's ok. I deal with it.
Again, I hope this was helpful and I'm happy to take any questions.
- JD
Great post. Very interesting read for someone like me considering going from public (MF) to PE.
Great write up. Appreciate you taking the time to go into such detail. How difficult was the switch after you decided you wanted to move to the public side? And had you always been interested in public investing? E.g. setup a brokerage account in high school and trade on your own dime?
It was difficult. It’s not an immediate layup to get a public markets job just because you work in investing. Or well it certainly wasn’t for me.
While in PE, I started putting together investment memos with models on ideas I thought would be interesting and started sending those out to recruiters and to be people at random funds I knew. One thing led to another and after several interviews, I finally received an offer from a place that I thought was a great fit with my investment philosophy.
I did invest my own account and began to invest a little for family and friends as well. That did help make the case I guess to recruiters that I genuinely was interested in making a transition
how were you able to invest your own account? Did your PE firm let you do that?
Thanks for the detailed write-up. What are your thoughts, if any, on the activist hedge fund space? Do you think that there's a real distinction between more aggressive firms like Elliott and more "collaborative" ones like ValueAct?
I honestly don’t feel like I’ve got a good answer to that question as we don’t do any kind of activism (whether it’s direct in your face proxy battles type stuff or even the “soft activism” many funds engage in these days). Elliott and ValueAct are both unique animals - they each have their place and are both highly successful approaches in their own right. Just because I may not be philosophically in agreement with what Elliott does doesn’t mean I don’t respect their work/ persistence/ thoughtfulness.
Sorry I don’t have a more thoughtful view for you
Excellent post. Really thorough break down. Thanks.
Only thing I'd take issue with is the diligence / mgmt exposure aspect. While I agree with you in that both statements are true, its not as though PE people are better at diligence / put more thought into it, which is how your post comes off. The reality is in public markets vs pe you aren't in the same stratosphere of information. This is regulatory driven plane and simple. **edit ** There are actually a number of reasons why that are not just regulatory, such as not wanting competitors to see detailed public disclosures, not wanting investors to share info with other mgmt teams, lack of 6-9 month deal exclusivity, just to name a few. **
I wouldn't lose respect over anyone in the public space because diligence doesn't compare to PE - its literally apples to oranges. While lame, obviously management isn't going to be as forth coming because of regulatory issues and even at 2-3% that's nothing in terms of ownership. I think it actually makes the job harder than PE in many respects. It's way easier to make decisions with close to perfect information than not.
I think you may have misunderstood what I was saying so let me clarify-
1) Re diligence, you absolutely do have the opportunity to do detailed and thoughtful deep due diligence in the public markets. And you can be creative while working with imperfect & limited information- you’re absolutely right there. I’m taking issue with the value investor types who say they do this so called deep due diligence but many haven’t even read the damn 10K properly before entering positions because they heard about from their friends.
2) Re mgmt teams, I’m complaining because I don’t like the regulatory constraints they have to operate under and I wish we could have PE styles detailed knowledge sharing sessions whether in a formal setting I.e. a board meeting or just over the phone. I don’t like that we have such limited access. I’m not saying there’s something they or us can do about it- it is the nature of the beast and I have to accept that. That’s all. This is purely my personal issue w working in a public mkt setting- it’s a trade off I have to accept.
For sure - just wanted to clarify while frustrating there are inherent limits - I've been on both sides as well. I do think some people actually struggle initially in the PE to public transition due to that aspect but once you get used to it its fine. And to your point - there is a reason why the term hedge fund hotels exist, ha.
I like to the of PE as getting married where public side is like dating. PE you are locked in for the long haul, public you can somewhat easily move in and out of names.
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Glad I could help provide you with some insights. Lots going on below the surface that LPs are unfortunately not privy to
All this thread did was convince me of the opposite - that private markets are better...
This is a question that I've been struggling with recently, and this post is very insightful -- so thank you. I had a couple of questions:
(1) Do you think that your experience in PE has made you a better public markets investor? I've talked to some people in the HF industry that have similarly transitioned from PE, and they have argued that the opportunity to hone their processing skills (i.e. model) in PE have helped them tremendously at their respectinve HFs. While I see the merit in this argument, I wanted to ask for your opinion on how necessary it is to go the IB->PE->HF route, rather than go directly from IB->HF.
Again, I greatly appreciate your contribution. SB'd
This is a very good/difficult question. I do think it’s helpful. Couple thoughts:
1) I think what being in PE does do is it shows you how difficult it is to run a company day to day and gives you an inside scoop of all the blocking and tackling requires daily to operate a business.
I hear pitches all the time where if only a company’s EBITDA margins could be improved from 25 to 35% and it could be run “more efficiently”, and if it’s multiple “reverted to the mean”, the stock would be a home run. Do you think you’re the only smart ass that stumbled upon that insight? Do you think the management team is not aware that their margins are lower than competitors? Do you really think they can accomplish that magnitude of margin improvements in the next 3-4 yrs without impacting their growth profile and in some cases impairing their businesses significantly. It’s easy to throw out the term “operating leverage” but having been on the other side of the fence working with these teams to accomplish margin improvements, it’s just not that easy.
All that is to say that having been in PE, I know there are some extrapolations built into consensus estimates that will never materialize and maybe that’s a behavioral “edge”. I don’t know.
2) It helps understand M&A a bit better and gives you insight around capital allocation decisions.
3) I think the other part that’s helpful is understanding compensation better. This is important because ultimately incentives drive outcome in every business. Being part of compensation structuring discussions and negotiations in PE helps provide me some context when I read proxies.
4) Now all that said, when I left banking, I genuinely did want to move to PE. I didn’t spend much time or give much thought to HF recruiting until midway through my time in PE when I started taking it seriously. So yes, PE helped before moving to an HF but if you really want to be a public markets investor while you’re still in IB, go for it. Don’t do something you don’t want to do just to conform to “the path”.
5) Regarding the edge in PE, because you have majority control or significant minority control, and you have control over all corporate and board level decision making, this edge is a little irrelevant and outcomes vary dramatically by which firm you choose to partner with. Edge becomes important in public mkt investing because neither you nor the other investor has any control over the ultimate outcome. Also you and other investors can have widely varying views of what intrinsic value is, what discount to intrinsic value you re comfortable buying a stock at- instead of edge I’d call it “variant perception”.
6) I know what you were trying to get at though with your question. Yes there’s a lot of money flying around and yes dry powder is at a record high, and yes valuations are high, but I do believe in PE as an asset class. There’s a LOT you can do with a company after you’re done acquiring it in PE. There’s an incredible amount of change you can affect over 3-5 yrs. Smart people do figure out a way to make money even in frothy markets, through thoughtful structuring, M&A, div recaps, leverage, etc. — there’s a 100 levers you can pull.
Thank you; that was very insightful
Did most people at your HF come from an IB background? How common is it for them to come from a BB S&T background?
Yes IB or PE. None from S&T except our trader who has mainly execution responsibilities (doesn’t do any research). I think you ll find that typical in fundamentals focused funds that require some level of modeling experience
JD - Thanks for the post. 2 Q's for you.
You wrote in a response to someone's post above that most people in your firm come from ib/pe. Why dont more people come from the research side?
You mentioned that you work 100% of your time on your own ideas. How do you source ideas? How long do you anticipate holding the stock, and what is the minimum return you expect? Can you share how you present the idea?
Thanks
It’s not like we re not open to someone from sell-side ER, but that’s how recruiting worked out at my fund.
If I began to share how I present an idea, I think that would probably require a whole separate post so I ll pass on that question for now.
Sourcing ideas — ideas can come from anywhere incl screens, keeping close track of the industries we cover, reading industry journals and attending conferences, mgmt teams themselves, from the expert network, friends at other funds, the sell-side. There’s not one way I’d single out from these- there are many different routes.
Re valuation, we arrive at an intrinsic value which is triangulated upon leveraging a combination of different valuation methodologies, and then seek to buy a stock @ 70-75% of that calc’d intrinsic value. We begin to sell as price approaches that IV or is modestly above it. Ideally we’re shooting for atleast mid teens IRRs on our investment over a 3-5 yr investment period.
Really helpful thread - thanks for answering all of these questions. Also in PE and considering the switch to HF.
How did you go about diligencing your current fund? In terms of capital base and investment style? I find that everyone says their fund has a "super sticky LP base and long-term investment approach" so would love to hear how you sifted through the BS.
Curious to hear your views on the HF market longer term. Were you at all concerned about shift to passive and fee pressures?
What does the promotion and responsibility path look like for someone in your seat, assuming you continue to perform and generate P&L? For those who do not perform, do you know where they tend to end up?
**Stickiness of capital base: **This is generally difficult to do, but one way is looking for fmr employees on LinkedIn. You'll be surprised at how many people are willing to speak/help someone out if you send them a quick 2-liner msg along the lines of "Hey I'm interviewing at xx. Saw you worked there, would be great if you could chat for just 10-15 mins". Assuming you're able to get a conversation in, you should be able to diligence the quality/stickiness of the LP base. Assuming you're not able to find any employees, see where the employees previously worked before they came to the fund you're interviewing at. If they're spinning off from a reputable source, that's a good thing and their capital probably comes from a stable source. I think it's also worth asking this question directly once you get the offer because it's a critical one. Generally for any place above $200-300M in AUM, unless performance has completely sucked over the last 5 yrs, you can assume you'll have a job for atleast a year. Plus if the fund is actually imploding, why would they be hiring anyway! Portfolio maintenance in HF is easier than PE so you don't need to hire an additional person to wind down a position.
Passive vs Active: This is a real problem in the HF/MF/public asset mgmt world and for anyone who tells you otherwise, they're lying. Even if performance has been very strong, you can expect some % of redemptions to passive. It's ok -- it is what it is. I'm not smart enough to predict whether there will be a rotation back into active management in a more difficult macro environment. You just deal with it, and move on and continue to focus on investing in high quality businesses at attractive valuations. That's really the best you can do.
Did I think about this being a career risk? Not really, perhaps I should have. In this industry, it's probably good to take it year by year. One of the options I did have in case things imploded was to go back to my prior PE funds so maybe that played into it a bit.
Promotion/Responsibility Path: It's quite simple -- you're either an Analyst (i.e. Investment Analyst) or PM (Portfolio Manager). It's VERY hard for people to make the jump and to be honest with you, I don't see a path to PM any time soon at my current fund (there are atleast 2 folks in line based on significantly higher tenure/responsibilities and I don't think I stand a chance in the next decade as my PM himself is no where close to retiring). That's ok -- I'm focused on continuing to develop my analyst skill-set for now, and it doesn't frustrate me. The day it does, I'll begin looking elsewhere for a PM promotion. Many people in this industry unfortunately have to switch funds to land that PM role.
As you get more senior, get in more positions in the book, and hopefully make $ for the fund, ideally the carried interest should tick up. The base and bonus beyond a certain point don't scale up all that much over time. At least that's how our fund works. Depending on what fund you're at, you can get canned if you don't perform for a couple yrs. We're a small/fairly lean team to begin with, and fortunately my PM's just not one of those guys to hire/fire quickly. We've had no involuntary attrition since he started the fund about two decades ago, so that should tell you something. That shouldn't however be misconstrued as complacency. We're all still here for a job, and that is to reward our LPs, and if things aren't working, there are certainly discussions had. The people who did leave either went and started their own funds, or accepted responsibilities at other funds. Typical I guess..
Just curious on whether you have considered going into entrepreneurship instead of hf after pe
No, that wasn't really a thought for me because I don't think I have the entrepreneurial bend honestly. If I did, I certainly would go that route. Just like every other analyst, I'd tell you that 5-10 yrs down the line, I'd like to start my own fund, and that's where I'd really be trying my hand at entrepreneurship. But that again depends on a variety of factors. Nothing entrepreneurial near-term in the cards for me.
Thanks for this, this is very interesting.
I have one question: when trying to transition did you ever consider doing the CFA? Was doing the CFA every mentioned to you by anyone you talked to? Are you considering doing it now?
I've heard that showing you're planning on taking the CFA can show and interest/knowledge in public markets and I was curious if you had an insight on the topic when it came to your switch.
Thanks in advance.
Just one opinion but I personally don't give much credit to anyone with a CFA, nor studying for it, in terms of reviewing a resume. If you really want to do it sure but if its mostly for breaking in I think your time materially better spent networking and developing ideas / pitches.
While there are certainly firms that require CFA or are CFA heavy, anecdotally I think those are in the minority and from a cost benefit of your personal time worth sacrificing.
I'd agree with ke18sb above. I was extremely negative on the CFA previously, and I think I still am, but I've toned down my criticism because in certain cases, it may be helpful. Let me elaborate:
(i) If you're a business or finance major, and/or worked in investment banking/corporate finance/corporate development/private equity before, the CFA is pretty much useless to transition to the public side. Some snotty "reputable" mutual funds require it and I've seen websites where literally everyone down from Partner to Janitor at this MF as a CFA. I think though that those types of firms are far and few between today, and the relevance of the degree has gone down over time particularly for those already in finance
(ii) If you DON'T have the profile above, but are trying to break into PE/HF, there are two routes you can take. Go for an MBA or go take the CFA. In that case, I'd highly recommend the MBA. While I don't have it (post for another time), I do see its value even if many of my brethren on the HF side like to bash it if they haven't gone. I graduated university coming out of a recession, and I know how powerful that network can be. All that banter around "the $200K opportunity cost" becomes irrelevant if you lose your job and are able to land another attractive one through someone in your MBA network. I think that's immensely valuable.
(iii) For those in the situation above, but unwilling to commit to a FT MBA (I get it- it's hard for many people to take 2 yrs out of their lives to attend especially if you have anyone depending on you), do a part-time one instead or do an exec MBA. I strongly believe any of those degrees are still more valuable than wasting your time studying for a CFA.
(iv) And if you still don't agree with any of my points above, and for whatever reason cannot get an exec/part time MBA, go ahead and do a CFA. It's still better than not having anything to show at all. But this is after you've evaluated where you stand based on points #1-3 above.
All around great post, wanted to touch on the advantages you need to truly have a variant perspective (informational, analytical, and trading). What do you think is your edge (yourself as an analyst or the fund)?
Also wanted to ask what makes your level of diligence superior to other public market guys? Genuinely curious because professionally, I feel like I'm at the point where I don't know what I don't know. I don't have a PE or a banking background, so I haven't had exposure to deeper levels of diligence. I'm never going to have access to a pay-to-play informational advantage (web scraping, satellite, purchased data sets...), so I'm curious if you think that an informational or analytical advantage can be attained through other avenues?
Since you've brought up the edge question again, I'll try and take a stab at it and pretend to act smart:
1) I believe my true edge as an analyst is knowing a couple sectors really well, so when one-time earnings events hit a stock I've been following for some time and it's also on our wishlist, we can look past what I think are short-term issues and either build or add to an existing position. I wish I were able to elaborate on specific examples here, but again in the interest of confidentiality, I won't here. But knowing a couple sectors well where your knowledge extends beyond surface level really helps. Honestly this is a source of "edge" anywhere, not just at an HF.
2) The answer to what makes our level of diligence superior is actually the way we're structured. We're extremely concentrated and if you compare the # of analysts at the fund to the # of positions we have, you don't have to dig too deep to realize why our diligence can be more intense. We typically research each prospect for 2-3 months, and we can afford to do that because we're not holding a 100 stocks (hell we 're not even holding 20). I don't want to use the word "superior" though because that's just pretentious- I'd rather use the word more detailed and deep just as a function of how we're set up.
3) We're a decent sized fund (again I'm not going to reveal AUM but it's fairly decent) and we almost never purchase web scraping/satellite/credit card data sets. Two reasons behind that: 1) we simply don't play in industries where that type of data is valuable 2) funds that do that are typically momentum driven/qtrly focused (even if they call themselves "long term" which is just BS). For funds like that, that additional data can be very valuable, but that's not our style.
I hate to break it to you man, but it's just good ol fashioned brute force styled diligence. We talk to a LOT of people, travel quite a bit not just to user conferences but obscure industry events most others don't care to attend (where no investors/sell side are present), and generally because of our level of concentration are able to have a better handle on industry developments/events affecting our portfolio companies because we can spend more time analyzing those events. When I say "more time", again, I'm comparing us to more diversified funds where the analysts just don't have the bandwidth to accomplish that and often leverage the sell-side in coming up with their theses.
The drifting focus away from investing is probably my largest frustration with PE.
My favourite part in PE has always been from the time a new CIM comes in the door, to the time we issue an LOI.
Pretty much anything post-LOI up to closing is extremely administrative and almost a box-checking exercise (at least in my opinion).
Right, and that's why I left...
"My favourite part in PE has always been from the time a new CIM comes in the door, to the time we issue an LOI."
So basically.. underwriting/thesis development, yeah?
Bingo.
JD - thanks for doing this. Am a 2nd year associate at a MM PE fund looking to eventually move to a concentrated long-only/long-biased HF for the reasons you mentioned. 2 questions:
Did you consider the MBA route? I'll likely go that route due to the desire to "take a break" post-PE
What do you think of attending Columbia and doing its Value Investing Program vs. attending HSW? Most people from my fund go to HSW (emphasis on the W) but the Value Investing Program looks awesome. And my understanding is that you can take a lot of the courses even if you don't get in to the program.
I have a friend who runs his own HF and is a professor at CBS Value Investing Program. He has recommended top students of his to me and his other friends over the years. I never wound up hiring one of his students at my HF, but that is certainly an advantage. If it were me, I would probably go to HSW though since none of my friends from bschool with your background (2+2) had any issues making the transition to HF.
I did consider the MBA route -- I think it's a legitimate path to take post PE to explore your options (you may do an HF internship and decide it's not for you after all - I've seen that happen for people, and given you're in school, its a risk free option). For personal reasons, I chose not to attend. I'm not one of those people who's going to sit here and crap on MBA programs just because I chose not to attend. There's immense value to them that becomes more readily apparent more years down the line.
HSW as well as Columbia are all great. The VIP at Columbia is obviously awesome. But I wouldn't stress on it in your application as the sole reason you want to attend CBS. The CBS folks are cautious about admitting people in whose only goal in life is to the attend the VIP program. It's a highly selective, small class and CBS ad com doesn't want people who perceive their experience to be shitty at CBS if they don't get in. Be careful about that.
As someone who walked the same path, I can confirm everything OP said is true. One question - you mentioned you have "skin in the game" now. Does that mean you have to invest in your own ideas / fund? Am also curious if there is a meaningful deferred feature to your comp that your fund implements.
I meant carried interest by "skin in the game". We don't have to invest in our own ideas or the fund. Carried interest vests on a multi year schedule and for that reason obviously has a deferred component (the mechanics of how the carry is paid out are different at each fund but what's consistent is 99% of the funds out there will vest your carry on a 3-4 yr basis, or some other 1+ yr period). My carry vests on a 4 yr schedule, with 25% paid out at the end of each yr, and 75% rolled back in the fund that grows w/ performance over the next 3 yrs. Then the next yr, I receive another 25% of that carry from Year 1, plus addn'l carry based on how the fund performs in yr 2. I again receive 25%, and this carry vests for 4 yrs as well on its own schedule. This is perhaps too much detail but you get the point- there's definitely a deferred compensation component in order to retain talent.
It's not too much detail, and I have a similarly painful but understandable feature!
How often do you think about the competition and the longevity of your career?
I'm concerned about mine. There are tons of incredibly smart people investing in public markets, more entering all the time and the industry is already super crowded. Working at a fund has made me feel completely and utterly average and you have to be exceptional to really make money.
Yeah but what industry is not hard/supercrowded? I think if you do deep and sincere work, you can still stand out regardless of how many incredibly smart people enter the industry. I think it's good to feel average so it pushes you to do more/better work than others.
If it helps, I've noticed that some of these incredibly smart people actually suck at their jobs because honestly, they're sometimes too smart for their own good. It sounds silly to hear it but I've heard pitches where some smart ass highlights some obscure crown jewel within a company that "no one is paying attention to". Well Mr Smart Ass, the issue is that hidden crown jewel may remain hidden for a longer period of time than you think unless you're willing to engage in activism to push your agenda. Sometimes simple is just fine.
If this career doesn't work out, I might consider going back to PE or something non-finance related. I'll figure something out. It's ok -- there are enough jobs out there. Not being complacent here, but just living in constant fear of becoming irrelevant doesn't help either.
How possible is it to go from back to PE if you were an associate in PE, went to a HF, and decided it wasn't for you? Would be much more intrigued by the HF route if you don't get pigeon-holed (in case it doesn't work out / isn't what you were looking for).
Fair points. I'm in the midst of considering a career change so I'm a bit focused on the downside as there are a bunch of reasons (that we are all well aware of) to think the industry is going to consolidate a lot and excess returns will continue to diminish. The time horizon for these changes could be very long and I'm not saying you can't have a great long career in this industry - it's just good to know how others are thinking about managing this change. I'm looking at something I can stay in for the long-long haul so this growing instability doesn't look great to me.
I understand - good luck with it. Perhaps the fact that I have the option to go back to my prior employers provides some cushion but I agree with the points you've made. It's wise to keep all options open amid all this uncertainty.
As Bezoz says “your margin is my opportunity” I see what you mean.
At the same time, the 2008/2009 has led to a big shift of the money from the banks to funds and HFs. Currently market makers have just a fraction of the money they used to have for prop trading. So the HF (and PE) industry has ballooned and sooner or later a downturn will arrive and leave someone behind. A lot of money has also moved to the passive investments (either ETFs or mutual funds that tend to follow the benchmarks) and when the correction will arrive some people will change their mind on the smartness of just throwing cash into ETFs.
Having said that, the margins will more likely than not continue to shrink, but capable money managers should be able to make a (good) living anyways.
Thanks johndoe89, great post. I am considering making a move from MM PE to HF for many of the similar reasons you mentioned.
Related to your point around decision making and fund cycle, it could just be my experiences but I have noticed that in PE the leaders tend to have more hubris . For example, after some great exits, the overconfidence leads to doing some questionable deals or at least at questionable entry prices.
From what I have seen and read of public value investors, they seem to be very humble. Your writing style also comes across that way.
Would be interested to hear your thoughts on temperament between PE and HF?
Thank you, I appreciate the comment. I think humility is about the most important quality one can have as an investor because the day you stop being humble, you stop being hungry, which leads you to stop learning and ultimately becoming irrelevant very quick. That’s the philosophy I’ve always tried to live by, whether in PE or the public world.
Now I think your point is interesting though and I can offer some insight into why that could be the case:
1) Daily vs Qtrly Mark-to-Market- In the public markets, you are marked to market by an EXTERNAL force, either validating your thesis or refuting it. Public markets are unforgiving. If you’re not humble about your ideas/investments and a stock you pitched starts going against you, you can end up looking like a fool even if you’re a successful and generally well regarded investor (think about what’s happened to the reputations of folks like Einhorn and Ackman over the last few yrs even though it is a well known fact that even the best investors are only right 60% of the time). Regardless, your activity is generally open for the world to see, and people by nature are jealous and like to talk more about your failures rather than successes, so not being humble can really hurt you in a difficult period for your fund.
By contrast, PE “marks to market” its portfolio INTERNALLY every quarter based on its OWN estimate of valuation. Every fund typically ascribes a certain valuation to each asset in its portfolio based on recent/projected performance and precedents/DCFs etc. I cannot think of one PE fund that’s not massaging the #s to smoothen out any speed bumps along the way. Unless a portfolio co is going public, folks in PE can generally operate under the radar and continue to pretend business is great as usual. Since validation will only be received at the time of exit, PE investors don’t need to worry for some time about anyone giving them crap for a bad monthly or quarterly performance. The public guys do and that’s what forces them to stay humble.
2) Recruiting Intensity: The PE world is EXTREMELY regimented and honestly incredibly stuck up when it comes to recruiting — they want people from top schools with prior IBD experience at the very minimum at the junior level and with many yrs of prior buyside experience at the mid/senior level. This structure naturally can create inflated egos because most folks who work in PE have slaved away for yrs attending prestigious high schools, then getting admitted to Ivies and busting their ass again to go to “high finance” ie IBD in this case and then when they ultimately land a position in the “promised land” of PE, it’s not hard to convince themselves that they’re hot shit and god’s gift to mankind (Make no mistake, it is NOT easy to work in PE and the reason the process is so highly selective is because of the strong technical skill set you need to have and the myriad responsibilities you need to juggle to get a deal done).
My point simply is the admission process is difficult to begin with, so for those who’ve made it past the velvet ropes in the club, it’s difficult not to have a bit of pride. Depending on where you join, the HF world is slightly more forgiving on your background and is looking to assess intellectual horsepower more than your ability to run a deal process. People tend to come from a variety of backgrounds into HF.
Hope this helps
Definitely agree.
A couple of additional thoughts - this conversation is getting more and more interesting as it goes on.
Despite humility is fundamental to be able to question whether or not your thesis is correct, you need to trust yourself to have a out of crowd view. This applies even more to public markets thank private ones, especially because the private investor - being the owner of the business - can decide to make changes to the company and adapt it to the market. For a non-active HF (which is the case of the majority of the HF) there is no influence in the company. So yes, there is a difference in terms of temperament and this could perhaps be a trait for young professionals to ponder when they are heading to a career in investment management.
Another aspect, as HF is just as glamorous as PE and the path to the first one is even more undefined, you might think that you are even more blessed to be into HF, while PE is (more) following a uphill path. It could be a demanding walk it, but it's not that impossible to do it. Somehow, HF could be seen as the dream job you don't even know how to get to it.
Thanks for doing this thread.
You talk about buying at a 25-30% discount to intrinsic value, and how your edge is knowing a few sectors well so you can step in quickly when they get temporarily knocked down by bad earnings. Any reason you decided to go with this expression of fundamental investing, versus say buying compounders at intrinsic value, sitting in them forever while your intrinsic value grows (Buffett)?
Do you think about intrinsic value literally as the sum of discounted cash flows (which implies a company on the cusp of a cyclical downturn has a lower intrinsic value than the same company on the cusp of a cyclical upturn - because you're getting lower or higher cash flows imminently)? Or do you calculate intrinsic value based on through the cycle earnings, and try to buy at a discount to that, essentially ignoring where the sector is at in its cycle?
Take a sector like autos, say earnings are at cyclical peaks, everyone expects them to go into a cyclical downturn, so they are already trading cheap on through the cycle metrics (EV/IC). Even though it may be cheap based on those through the cycle metrics, and you should be fine in the long run, I wouldn't want to touch something headed into a down cycle because news flow and price action is probably going to be dismal for the next 1 to 3 years. Curious to hear your take.
Of course our goal is to buy compounders - as fundamentals focused investors that's basically what we're looking for. But entry valuations matter and hence the focus on buying at a discount to that intrinsic value. Remember a great business purchased at an onerous price may still not make for a great investment from an IRR perspective. From time to time, the market does give you opportunities to buy phenomenal businesses at a discounted price (think about what happened in October) - we wait patiently for these "shocks" to the system to get aggressive but until then we're perfectly happy just continuing to add more names to our wish list.
We stay away from cyclical names in general because I don't think we're very good at timing the cycle. You can certainly base valuation on a through-the-cycle earnings type analysis, or leverage other sources to calculate intrinsic value. On the valuation point, we use a combination of methodologies to arrive at an intrinsic value estimate - the DCF is definitely one of those pieces of analysis, but there are several others including private value, SOTP, precedents, public comps, LBOs, LTV/CAC driven models- there's many different ways to value a business and we try and look at all of them.
Thanks for that. If I may, just a few follow ups:
It seems like you are more focused on buying great businesses at a discount and then selling them as they converge back up to your estimate of intrinsic value. Someone like Buffett, on the other hand, seems to hold stuff even as they sit at intrinsic value, as long as that intrinsic value keeps growing year after year. I might be misunderstanding something here, but it does seem like your approach towards exits is different in that regard, so was curious why that was the case.
When you say you ignore cyclical sectors, do you mean just the really obviously cyclical ones like autos, or does that extend to anything that has a whiff of cyclicality to it? For example there are a quite a few high quality compounders in the industrial tech space that are still subject to (albeit dampened) fluctuations tied to the cycle. Would you consider those to be cyclical as well? (Happy to chat specific names over PM if you'd like.)
johndoe89 Thanks for the great post. As someone aspiring to be in the L/S equity space in the long-run, do you think there's enough merits to doing banking and/or getting private markets experience vs. joining a buy-side fund (whether HF or AM) straight out of undergrad? When I see the profiles of some well-known HF managers, it doesn't seem uncommon to see them come from a banking background so I'm wondering if there's a specific set of skillsets that they pick up from banking that can't be learned elsewhere. Essentially I'm comparing trade-offs between banking and AM/HF out of undergrad. I would love to hear your thoughts!
I get this question a lot (should I do PE or HF straight out of undergrad and skip banking altogether or do I need to go the IBD route) so let me share some thoughts.
— You don’t need to go do banking if you can directly get into a PE or HF/AM program that is a) STRUCTURED and b) is a STRONG BRAND. If it fails any of these two tests, my recommendation is to go to a well-reputed investment bank instead even if this is the career you ultimately want.
— Why did I say that? BECAUSE PEOPLE CARE ABOUT BRAND. As I mentioned in my story, I went through a bulge bracket program and then to two middle market PE funds. Nobody outside of the PE world and definitely outside of finance knows the names of those PE funds but anyone who is even halfway knowledgeable about business knows the name of where I started. The brand also helped when applying for MBA programs.
— My BB experience also really helped me with my personal branding when it came time for HF recruiting. My PM definitely cared that I had my cut my teeth in a traditional IBD program and this likely had the modeling/ technical/ presentation chops the job required. He also knew that because I had been through something that intense, I was used to handling high pressure situations. He probably prioritized my investment experience at the end of the day but it did make a difference to him that I worked at a BB previously so he could tell people that story while marketing the fund.
— My point of saying all this above is by all means go to a fund directly if it offers you a powerful enough brand you can leverage in the future. If it doesn’t, prioritize the IBD route. Brand matters and becomes more and more important the more senior you get in your career. I know I’m sounding like a bit of a “prestige whore” here but hopefully my points above logically explain why I think this way.
— finally I don’t think this is a “skill set issue” but going the IBD route allows you to preserve your optionality. Think about it like delaying your graduation a couple yrs and coming out a bit smarter about how the working world operates. This is again a very important point that college undergrads don’t understand/appreciate. When I started out in banking, literally 99 out of 100 kids in my Analyst program wanted to do PE. But as they went through their yrs in banking, many wanted nothing to do with PE anymore. They wanted to go join tech cos or start businesses or go the VC route or corp dev or do other interesting things outside of finance.
— I’d say pretty much 100% of my class ultimately got whatever they wanted to be in because IBD gave them a broad exposure to an intense working environment where you picked up tangible skills like modeling/forecasting. Had I joined a HF directly out of school, I doubt I’d be very competitive for a VC role because they’re separate animals. But if I wanted to do VC after banking, that was definitely an option I could pursue with my background.
Agree with all these great points (at least from a PE point of view).
I have seen PE interns who want to "skip" the 2 year IB route in favour of going straight into PE. Usually the funds that have that option are not well known so they are really rolling the dice. If it doesn't work out then their ability to point to a proven brand when they are back in the job market is tough.
Thanks, that's really helpful to keep in mind!
Based on what you have described, I think I would really enjoy HF work. My favorite part of the process is researching companies and writing reports. Up to now, I've assumed that ER would be the best way to have a career in what I most enjoy, and I wasn't sure if it is still reasonable to assume that I could work for someone else for a few years before starting my own fund. But to get to the point, what internships would you recommend for someone in my position (Soph. @ Non-Target)? Thanks for your time!
I think looking for a corporate finance/investment banking internship is the way to go. These are hard to come by during your sophomore year so try and intern at a boutique wealth management firm in your hometown if you can. If you hustle enough, those types of internships aren't hard to come by. Then keep up a strong GPA and apply to good investment banking/equity research programs the following year. Equity research is a good route to get to HFs but for some reason I do see more ex-IBD/PE guys at HFs than ER. There are many reasons I can think of why this is the case (too many to elaborate here) and so I'd recommend going the tried and tested IBD route vs ER.
Thank you for the advice!
Now that's a great post. Thank you!
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