Friday Letter It's in the numbers

Investment bankers and their inflated bonus schemes have become the latest point of focus as people debate the cause and effects of today's financial turmoil. But as Terra Firma chief Guy Hands pointed out this week, the private equity industry’s traditional compensation structure is far from the investment bank bonus culture and - crucially - does not incentivise disproportionate risk-taking for personal gain.  

General partners often have to wait years for their hard work to pay off in the form of carried interest. While this can ostensibly cause some fatigue – particularly when GPs see their colleagues in other segments of the finance industry regularly collect staggeringly large annual bonuses – they’re actually much better off than some of their financial services friends.

Guy Hands, chief executive of buyout giant Terra Firma, said this week he expects GPs will be taking home 75 percent less cash in coming years. This is, of course, to do with market conditions that are slowing the pace of both new investments and exits, which translate into longer hold periods and hence funds taking longer to generate returns. There are also likely to be some duds in portfolios that were assembled during our most recent credit boom that will stay in the workshop for far longer than planned.

Hands was quoted heavily as saying that this compensation drop is a good thing, which was misinterpreted by some as something along the lines of “GPs should earn less money”, or that the private equity pay structure should be overhauled.

PEO did not attend the conference in Asia where he made the comments, but a look through a rough draft of his speech and a chat with Hands’ spokesman confirm that what he meant was this: Private equity’s long-term compensation scheme benefits both the GPs and their investors because good GPs not only have carry riding on the outcome of their funds, but their own invested capital as well. And for the foreseeable future, GP compensation is going to be lower as results are going to take longer. 

This – along with the presence of hurdle rates in fund agreements that see reward begin to flow to managers only once investors have received a meaningful return – means GPs rejoice and suffer along with their LPs, and, importantly, are in it for the long haul. This is precisely the opposite of investment banking’s short-term bonus culture that can in turn lead to disadvantageous short term decisions.

Let's not forget, too, that, unlike investment banks (one of which just sent 1,100 workers packing this morning), private equity firms can put their capital to work or to rest, dependent upon opportunities that arise.

If this week’s to be a guide, we’re likely to see quite a bit put to work over the coming months: publicly listed Fortress Investment Group, for example, has forgone a third quarter dividend in order to fund more deals. Meanwhile, Sydney’s AMP Capital, the US’ Providence Equity Partners and Europe’s Palamon Capital Partners were among firms that announced new hires to strengthen investment activities.

While it may take longer for these teams to see the fruits of their labour, this, too, is a good thing. GPs are not focused on what will happen tomorrow – they are not left wondering if they might need a cardboard box next week, nor if their annual bonus is in jeopardy – but rather are focused on long term success that they will share with their investors.