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Culture clash

Private equity firms must learn to better compete against hedge funds and investment banks for junior-level hires. By Ben Aymé

For many years now, the private equity industry has turned its gaze towards investment banks or management consultancies for its junior level recruitment. These provided large pools of intelligent, numerate, hardworking and well trained individuals who were easily seduced by a mysterious and enigmatic industry. Most funds, fearful of becoming top heavy, hired these analysts on two- or three-year ?pre-MBA? programs. This arrangement suited everyone – analysts found the work more interesting, gained new skills and were comparatively well remunerated as they needed to fund their MBAs.

However, since 2000, three significant events have affected this natural equilibrium. Firstly, with the heyday of 2000 over, investments banks and management consultancies had to severely cut their graduate intakes in 2001, 2002 and 2003, in some instances by as much as 70 percent. Secondly, both the private equity and hedge fund industries doubled in size between 2000 and 2005. Thirdly, the resurgence of M&A and strategy consulting activities in 2004 and 2005 means that investment banks and management consultancies respectively are keener than ever to retain their high performing staff.

The changed recruiting environment means private equity firms will need to offer more to young hires. Private equity employers will also need to be more attuned to looking for candidates who make good fits with the culture of private equity.

young professionals, the lures of the private equity industry have traditionally been: Principal, as opposed to advisor, status; an entrepreneurial culture; higher levels of responsibility; less bureaucracy; greater control over the process; greater intellectual challenge; greater involvement in business and operational issues; and higher long-term financial rewards.

With the surge in private equity activity globally, the industry has matured and its actors have both professionalized and institutionalized their processes. Large buyout funds are now structured along investment banking models. The institutionalization of the funds has not only eroded some of the ?mystique? surrounding the industry and its actors but also suppressed the ?entrepreneurial? appeal to some sections of the investment banking and consulting population.

Hedge funds have provided a natural escape route for analysts reluctant to go to business school. As hedge funds increasingly move into the private equity industry's deal landscape, the skills acquired in buyout funds have become invaluable, and therefore younger private equity professionals are being recruited by hedge funds.

Historically, traditional event driven, risk arbitrage, long short equity and value hedge funds have grown by hiring top ranked investment banking associates who are valued for their analytical skills.

Over the last few years, the investment landscape has been fast evolving with hedge funds edging into the traditional private equity territory. Hedge funds are proving to be extremely agile foes, capable of making investment decision and building stakes in their targets much more quickly than traditional private equity funds, which are tied to strict investment committee protocols.

Culturally very different, hedge funds are used to quick and opportunistic decision making processes and short- to midterm exit strategies. Moving into private equity home ground requires an evolved investment rationale or at least a clear understanding of their competitors' thinking. Increasingly, traditional private equity skills, from valuation methodology, operational scrutiny to board activism, are sought by hedge funds.

So hedge funds are not only emerging on the private equity industry's investment field but also on its recruitment hunting ground.

The lure of hedge funds for private equity professionals are: significantly greater annual management fee per head; less bureaucracy and greater investment flexibility than traditional private equity; higher chances of success; and shorter term returns than private equity and therefore higher shorter term payouts.

At the pre-MBA level, professionals in large LBO funds should expect total compensation ranging from $150,000 to $250,000. Professionals with similar years of experience in bulge bracket investment banks are expecting between $200,000 and $450,000 for 2005. The earning potential in hedge funds is much greater but so is the downside. A strong performer in a bulge bracket hedge fund with 3 to 6 years of post-graduation experience can expect earnings between $400,000 and $1 million.

Of course, returns in private equity are measured over much greater time spans. However, this is of little importance to candidates who will be expected to go to business school at the end of a three-year tenure.

Cultural differences
A private equity firm eager to compete well against hedge funds will need to fine-tune its recruiting strategy based on where geographically candidates are being sought and what other career options the candidates may be considering.

Europe vs. US. Europe does not have as strong a business school culture as the US. Most continental European graduates will have spent four to six years in undergraduate education and will feel the opportunity cost of spending a further two years at business school to be too great. Furthermore, young European professionals, influenced by previous generations, still feel the desire to commit long term to their employers and expect this notion to be reciprocated. This feeling is fueled by traditionally higher levels of unemployment and more rigid employment laws. Therefore, Europeans generally feel uneasy about adhering to a finite employment contract.

Another major cultural difference between the US and Europe is the importance of work/life balance which is much stronger in Europe. Europeans have traditionally believed that a move out of investment banking or management consulting into private equity or hedge fund would improve their quality of life. The change in status from advisor to principal favors the holder of the purse and his or her ability to control their own agenda. In reality however, private equity professionals working in large buyout funds find themselves competing in many simultaneous auction processes with strict deadlines imposed by the seller. This has not gone unnoticed by some European analysts and associates who regard claims of an improvement in work/life balance in private equity with some degree of skepticism.

Private equity vs. investment banking. When luring an analyst or an associate out of an investment bank, it is important to focus on the person's core motivations and the benefits of moving into private equity. Investment banks are using increasingly aggressive tactics to prevent their high performing staff from departing. Fortunately, their tactics are predicable and (usually) easily circumvented. They tend to come three forms: The sympathy appeal; the ?any team you want? promise; and the guaranteed cash compensation.

The first two approaches are usually delay tactics used to stall an employee until a suitable replacement can be found or trained. Unless a person's desire to leave is solely financially motivated, the fundamental motivations such as the quality of work, intellectual challenge or lifestyle are unlikely to change in the mid- to long-term, irrespective of compensation levels.

As a last resort, it may be required to explain to investment bankers or strategy consultants that they will not have many chances throughout their career to move into the private equity industry. Should someone decide to stay put for another two years, it may invariable mean shutting the door definitively to the industry.

Private equity vs. hedge funds. Hedge funds can be extremely aggressive investors and likewise, extremely aggressive recruiters. However, they do not have as many recruitment tools at their disposal and most people are simply attracted by the potential earnings on offer. While large hedge funds can afford to pay high basic salaries and bonus from the management fee alone, long term earning potential is more opaque. Increasingly, margins are being eaten away by fierce competition and the predictions for 2005/2006 are far from attractive.

Hedge funds have been quick to move into the private equity landscape and have attracted a great deal of media coverage in doing so. However, few have yet the tools necessary to live with an underperforming investment requiring either operational or financial turnaround. Furthermore, while they can ?get in? fast, they may find themselves unable to exit just as quickly and this will put undue stress on an investment committee or an investor base lacking long term perspective or indeed patience.

We have noticed an increase in the number of professionals looking to leave the hedge fund industry. Outside of performance issues surrounding the individual and/or the fund, the motivations for leaving have partially to do with stress and culture. Stress levels can be particularly high, especially when an individual has to explain why a position is moving against the most rigorous analysis or rationale.

Finally, some hedge funds can have a particularly aggressive culture or be led by an egotistical figure, and depending on the provenance or training of newcomers, adjusting to such an environment may prove to be too demeaning for some individuals.

For private equity funds keen to hire pre-MBA candidates on 2 or 3 year contracts, investment banking analysts, especially in Europe, need to feel little or no opportunity cost. Private equity funds may therefore have to match if not better cash compensation levels currently offered by the top tier investment banks.

However, should the structure allow for promotion beyond those two or three ?probationary? years, then funds can avoid this mercenary trap by ensuring that potential hires buy into the long-term incentives and benefits of private equity such as carried interest or co-investment schemes.

Hedge funds are proving to be fierce adversaries and in most cases will win a bidding war thanks to their higher average management fee per head and structural flexibility. One must not forget however that hedge funds and private equity funds are culturally very different and should not therefore have to compete for the same post-MBA or partner track candidates.

If you are a private equity fund and have lost a very strong individual to a hedge fund, I recommend waiting. Who knows, he or she may be back six months down the line?

Ben Aymé is head of the alternative investments practice at The Veni Group, a London-based independent search firm delivering exclusive recruitment solutions to the European financial services community.