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.
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