Private equity funds are supposed to be the panacea to every junior investment banker’s every problem. The work in private equity is supposed to be more interesting than in banking. The prestige is supposed to be higher. And the pay is supposed to be super. Setting aside the question of whether building financial models in a PE fund is really much different to building financial models in a bank, the latter plank of private equity’s model needs a little more scrutiny: the latest results from the world’s biggest funds suggest PE pay has taken a dive.
In the first half of 2016, Blackstone, KKR and Carlyle cut the amounts they set aside for employee compensation by 31%, 54% and 33% respectively. That’s bound to be painful. Even Goldman Sachs, which has been unabashedly harsh with pay and headcount this year, only cut compensation expenses by 28% in the first half.
So, why is PE pay falling? Blame ‘incentive compensation.’ And in particular (unless you’re at Blackstone), blame ‘unrealized incentive compensation’ – at KKR and Carlyle, unrealized compensation has turned negative this year.
How can compensation be negative? It’s all down to the vagaries of private equity pay. When you work in PE, you typically earn a salary, a bonus based upon management fees paid to the fund, and carried interest. Carried interest is the proportion of the profits that a fund gives to its staff when it exits (sells) its investments. ‘Realized’ carried interest is comprised of profits that have already been made and distributed when investments are sold. ‘Unrealized’ carried interest reflects profits that will be made and distributed when existing investments are exited sometime in future.
It’s carried interest that can make working in private equity so lucrative. And it’s carried interest that seems to be falling into a crevasse. Carried interest is only paid out once a fund hits a particular hurdle rate (usually a return of around 7% to 8% on its investments). If future carried interest is negative, the implication is that the hurdle rate has not been met. And that’s bad news for anyone moving into a big PE fund (Blackstone excepted) in search of big pay.