I am starting my career as a private equity analyst as soon as I finish my undergrad. This category is dedicated to sharing my thoughts and experiences on the job.
Access all of my private equity posts by clicking HERE. Here’s a list of a few highlighted posts:
Recently the private equity industry has come under attack. As Mitt continues campaigning for the highest political office in the United States, rivals and media groups attempt to negatively frame his years of private equity experience as the founder of Bain Capital. Today I present counterpoints, and along the way, you may find reasons for loving Mitt too.
Opponents usually begin by framing the brown eyed, perfect haired Mitt as an elitist. They worry that private-equity firms, hedge funds, and venture capital firms are among the financial institutions favoring an elite club of investors. This is partially true; not everyone can “do God’s work”, but most can still get involved in the asset class.
Increasing efficiency in marketplace requires large amounts capital and an appetite for risk. According to the Securities Act of 1933, individuals with a joint net worth of under $1,000,000 lack accreditation. Regulation D plays a vital role in preventing fraud and determining an investor’s competence in court.
Few investors can afford the $5,000,000 minimum and ten-year commitment to an investment that pays no annual distributions. However, Congress does provide alternatives for the rest of us. Business development companies are listed investment companies that provide debt and equity capital to small, privately owned enterprises while providing greater liquidity and a lower share price for their investors. Just be sure to do your own due diligence before investing.
Another reason large investors are favored is to reach fundraising goals. The greater the scale, the greater the opportunity for higher compensation. All of the presidential candidates are millionaires. Mitt is significantly more successful than the rest, as he earned hundreds of millions of dollars. Misanthropes frequently fail to understand the sources of his fortune.
Mitt’s main source of wealth is carried interest. Carry stems from the 13th century Venetian merchants, who formed syndicates to invest in trading voyages. Upon a successful trip, the captain received 20% of the profits, whilst the merchants received their original capital and 80% of the gains. The system has endured as the vast majority of private-equity firms, hedge funds, and venture capitalist firms use this structure. Point being, if the firm doesn’t make a profit, neither do investors and the fund’s employees.
By running for President, Mitt has illuminated private equity’s capitalistic compensation system. The structure keeps the fund incentives aligned with investors so the management can focus on creating value. Additionally, since there are several private-equity firms competing, the worst performers are often forced to close shop. Being rewarded for results and survival of the fittest are bedrock American philosophies.
Subsequently, carry is then taxed at a 15% long-term capital gains tax. A tax rate that is enjoyed by entrepreneurs upon exiting, executives with stock compensation, and every individual investor to list a few. Mitt is a Mormon not a moron. He utilized tax shelters to lower his rate by an additional 1.1%.
Thankfully by running, problems in our US tax code have been highlighted. Excluding people no incomes or the unemployed like Mitt, the system is regressive because the vast majority of lower earners pay higher tax rates than the wealthy. Mitt has “been consistent since he changed his mind”, promising every hardworking American significantly lower rates if elected.
Capital is need to grow our economy, create jobs, and complete transactions. Getting to the level Mitt did in private equity takes years of hard work, perseverance, and competition amongst the smartest people in the world. His compensation reflects his success, the difference he made in improving capital markets, and is something that should be aspired to by every American.
Now let’s shift focus from Mitt’s compensation to Bain Capital’s revenue sources since many of the large private equity firms have been falsely criticized for being rewarded even as the target company goes bankrupt. There are two main ways a private-equity firm earns revenues for its management (GPs) and investors (LPs): fees and dividends.
At the heart of the GP and LP relationship must be trust and partnership behavior. Usually, 2% of capital committed to the fund is intended for the costs of doing business (e.g., salaries, travel, rent, etc.) and to ensure the GPs are supported even in the early years of the fund’s life. Management fees have increased with greater fundraising; however, LPs choose to continue paying because they are very happy with the returns compared to other asset classes. Poorly performing fund managers do have to “worry about getting a pink slip”.
Furthermore, private-equity enterprises like Bain Capital primary make money by restructuring the companies they purchase, improving operational efficiency, and then taking them public or selling them for a return. If funds are especially efficient at improving the business, they are rewarded with a return on their investment in the form of dividends.
By law, a company cannot pay a dividend unless it is solvent. Strict regulations hold the board of directors responsible for rendering dividends that could bankrupt the firm. Directors like Mitt were very careful before authorizing cash advances as they can be sued and criminally prosecuted.
Similarly, Bain has a duty to meet creditors and workers obligations first. While Mitt “likes being able to fire people”, the alternative to leaner, small firms rescued by private equity are bankrupt firms that don’t employ anybody. Private equity invests in financially distressed, poorly managed companies. These targets have low employment growth relative to peers.
If Bain Capital turns operations around successfully, the company can continue growing, hiring employees, and increasing wages. On the other hand, if the target fails, the private equity firm suffers, but the employees have still received paychecks and the runway to find new jobs.
In the end, LPs are satisfied, the target’s previous shareholders are compensated, and workers engage in career development. Rarely is there an industry that delivers so much value for all of the partners. Healthcare, education, and the food industry are a few of the industries that need comprehensive reform, and yet fail to be the focus of rivals and news outlets. Overwhelmingly, citizens are bombarded with issues that affect a very small portion of the population and which convolutes decision-making.
The main reason I love Mitt is because he has reminded Americans of economic reasoning. Everything has costs and our federal republic system is no exception. Jon Stewart and Stephen Colbert have accurately pointed out the power of super PACs as modernized mechanisms of bribing politicians.
Would you like to make a ten thousand dollar bet? Learn from the private equity model. Focus on getting rid of lobbying and making the process more transparent. That way Americans will have politicians whose interests align with their constituents.
This is one of the videos I saw before my private equity interview. It’s a typical Q&A firm presentation, except for the fact the professionals are London based.
Happy New Year! As you may have noticed, it has been a while since I written anything considerable. I am happy to announce that is because I was just too busy landing, accepting, and celebrating my offer to work in private equity.
Excitement aside, I’m ready to get back to sharing my experiences more consistently. Here’s a glimpse into posts to come this year:
I have had a blast writing this year! It has helped me organize my thoughts and share them with other. Here is to an even better 2012. Cheers.
My takeaways from the image:
It is also interesting to see the dealmakers on the sides of the image. One of my favorites is Balckstone’s Steve Shwartzman.
Source: The New York Times
Background Story (Personal Rant)
The other day I was sitting in my money and banking class in a top 20 (U.S. News Undergraduate Rankings) business school. So far the class introduced me to monetary policy, the US commercial banking system, and touched upon the history and causes of financial bubbles. The book, Mishkin’s Money, Banking, and Financial Markets, is fairly simple to read and understand. I am grateful for this especially since the professor seems strikingly ignorant on the subject of banking. Forgiving the fact that he is one of the worst teachers in the school, and his class is completely pointless since I gained access to the test bank through the Pearson website- I still happily attend his class every week hoping to learn something new.
Recently, we were on the subject of the recent financial crisis and the professor mentioned private equity wasn’t doing so well, suggesting transactions made right before the 2008 crisis hit were steeply overvalued and it would be difficult for the firms to regain their capital, let alone profit from their targets. A student raised his hand and asked about the differences between private equity, investment banks, commercial banks, and hedge funds. I got excited to contribute, but my teachers response was completely wrong and he decided to strategically move on from the question quickly. Deciding it wasn’t worth correcting him, or even worse, insulting him in class, I kept my mouth shut. Below is an answer I would have given to my peer’s question.
Buy-side vs Sell-side (The Answer)
There are two general sections that divide the financial industry. The buy-side includes savers (people putting money into commercial banks), investment advisers who invest the savings, and funds that are given money to make specialized investments; and the sell-side consists of investment banks who are split into the sales and trading division and corporate finance division.
Here are more details on each of the parts:
Note: When I say raising money from the public, I mean anyone- companies, individuals, or institutions.
The Chinese Wall (The Investment Banking Division)
As highlighted earlier, there is a division in the investment banking (sell-side) department. The image above demonstrates this with an invisible wall in between corporate finance on one side and sales and trading and research on the other. This is set up intentionally to avoid conflicts of interest. Since the corporate finance department’s clients are companies, they hold access to insider information. Using the knowledge to publish research reports or trade would be against SEC and NASD regulations.
Wrap-Up
Hope that helps clear up this common question. I wanted to add the fact that picture above shows research on the sell-side (i.e. to complement sales and trading); however, there is also buy-side research sold to pension funds and mutual funds.
Regulation pertaining to the separation between commercial banks and investment banks is Glass Steagall Act, which was repealed by the Gramm-Leach-Bliley Act in 1999. Also, there is the Vocker Rule recently passed in 2010 separating investment banks and proprietary trading in banks. The main reasons for these regulations is to minimize conflicts of interest within a bank, to limit the size, and thus risk of the financial institutions.
Before I sign off, I also wanted to point out that private equity is recovering from the financial crisis, contrary to what my professor suggested. This trend is evident by the $3 billion J. Crew deal at the beginning of this month. However, PE trends are a discussion for another post, it is now time for me to attend another one of his lectures.
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