Thread by @PEBites

Private Equity compensation, a thread

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1/ PE compensation is, in my opinion, one of the most misunderstood concepts in PE most especially by young investment professionals that are joining firms who provide little insights into the long-term compensation schemes, which by the way vary greatly by PE firm. Let's start

2/ with the basics and for now I am only going to focus on mid-level investment professionals.. Partner-level schemes that include other comp like mgmt. fees, etc. will not be relevant for the majority of PE folks. At a high-level, PE comp will be comprised of 3 things: cash,

3/ bonus, and carried interest, the latter of which is typically where all of your upside is embedded. Most investment professionals are hungry to just make it to the buyside and hence gloss over important factors that play a huge role in their future earnings potential. I'll get

4/ to that in a moment. So cash and bonus are obvious. But how does carried interest work? Simply put, carried interest is the gains that LPs pay GPs on the profits earned above a certain preferred hurdle. Typically, this is 20% of gains above an 8% LP pref. For example, if you

5/ have a $100m fund that generates a 2x, that creates $100m of gains. The GP carry would be $20m, and the net LP gains would be $80m.. so 2x gross fund / 1.8x net LP returns. Staying on that example, the $20m of carry is then allocated across the firm to various professionals

6/ that have "points" of carry. So if as a VP I have 1 point of carry, I'm entitled 1/20 of the carry pool, or $1m. These figures are usually presented to you at the beginning of the fund carry allocation period and assume an estimated rate of return. What most younger investors

7/ do not appreciate is that this carry figure is 1) not actually real given it's highly dependent on fund performance and 2) the payment of said carried interest will be very far in the future. Typically, firms will not distribute carry until fund returns are de-risked so as to

8/ avoid a "claw-back". So on a 10-12-yr fund life, you MIGHT start getting carry pmts in year 7 and even then the pmts will be gradual over the remaining fund life. The $1m that is on paper is effectively much less once you account for time value of money. Ok, so that's how it

9/ works now let's discuss what this means for aspiring PE professionals. Performance and carry allocation are paramount when deciding where to work. For instance, if you join a MM PE fund that has a so-so track record and is raising their 3rd fund at $300m and you get 1 point,

10/ that earnings opportunity varies greatly from joining an established PE fund with an incredible track record raising their 10th fund at $5 billion where you only get 0.30 points. Regardless of your decision, you are effectively making a bet that the firm you join will

11/ generate strong returns at scale such that it is worth it to work there long-term (and I do mean long-term). I've seen time and time again young professionals join a PE firm b/c the job lands in their lap and they don't have a clue that the GP is actually struggling to raise

12/ capital or has never generated carry. I stress this point b/c once you are plugged into a PE firm, the long-term nature of carry vesting makes it such that beyond a certain point it becomes economically irrational to leave for another higher-performing firm. But I digress.

13/ Now let's unpack why PE professionals spend a majority of their early careers perpetually cash poor. I glossed over a 4th leg of the compensation stool which is the GP commit and/or co-invest. When GPs raise funds, they are required by LPs to commit capital out of pocket to

14/ the fund (typically 2-5% of fund size). This is a cash commit that is spread across all investment professionals (IPs) and is callable as the fund invests capital. What this creates is a dynamic where IPs are continually committing capital to 1 or more funds over their career

15/ which is being tied up in illiquid investments that don't generate returns for anywhere from 5-10+ years. Oh and by the way, you have to pay taxes each quarter on the phantom income that is generated on paper by your carried interest and GP commit allocations. As an FYI, your

16/ cash/bonus comp rarely exceeds your GP commit / tax obligations such that these are immaterial matters. As a member of the firm with access to PE investments, IPs are usually trying to max out what they can commit to each investment/fund so that one day far in the future they

17/ will be rich. So all of this is happening in your late 20s / mid 30s which, for most people coincides with other life events such as weddings, kids, houses, etc. The result is a dynamic where a substantial portion of your net worth is illiquid and technically hypothetical /

18/ dependent on the performance of your funds. Now, to provide a light at the end of the tunnel, the long-term discipline pays off big time once the cash spigot turns on. You go from constantly sending out cash with no return to all of the sudden a positive cash flow stream that

19/ will continue throughout your tenure. This is the end of the rainbow that all PE professionals are working to get to.. but it takes time and there is risk involved. You may never get there. Most younger people read Barbarians at the Gates and become immediately infatuated

/20 with the earnings potential in PE. And it's true, PE can be a path to extreme wealth. However, it's not guaranteed and will likely take decades of work to materialize. So in summary, PE comp usually consists of cash salary, bonus, carried interest, and GP commit, the latter 2

/21 of which are where the majority of earnings potential lies and take the longest to materialize. When joining a firm, know who you're getting into bed with. Is the GP top-quartile? Are they raising new funds at higher targets? How is the carry allocated (e.g., hoarding by a

/22 few partners or broadly shared throughout the firm)? It's not just about the initial offer.. it's about what the next 5-10-15 years looks like which can be hard to visualize in the moment but is critical to your long-term earnings potential. As always, there are terms and

/23 concepts that I had to quickly cover but am happy to unpack in further detail upon request. Happy hunting out there folks, best of luck to those looking to break into this crazy world. #PrivateEquity #carry #investing