Many aspiring finance professionals are attracted to the investment management industry for the eye-popping payouts that top earners are known to receive. In 2022, the founder and CEO of the hedge fund firm Citadel Ken Griffin earned a reported $3+ billion between his share of management fees and profits on his own investment in the fund. Payouts for top executives can be similarly huge in the private equity world. However, the compensation structure differs significantly between hedge funds and private equity, and it is important for junior professionals evaluating their next career moves to properly understand the nuances of each.
In private equity, the investment firm is known as the GP, or general partner. Typically, the GP raises committed funds from investors (known as LPs, or limited partners) and receives fees equal to 2% (the “management fee”) as well as 20% of profits (“carried interest”). The management fee is typically meant to cover operating expenses, although it can be a meaningful source of profits for firms with larger fund sizes. Carried interest is designed to align incentives between GPs and LPs, and is only paid out if the IRRs generated by the fund exceed a predetermined “hurdle rate” (usually around 8%).
As a private equity investor, your compensation will typically consist of three components: a cash salary, a discretionary cash bonus, and an allocation of carry that vests over a number of years. The cash salary and discretionary bonus are identical in format to what you see in investment banking, and amounts vary drastically by firm and by fund size. However, it is generally the carry allocation that can generate the most outsized earnings for private equity professionals. If you receive 100 basis points of carry in a fund, that means you receive 1% of the 20% profit share allocated to the GP. For example, if you work for a $1 billion private equity fund that generates a 2x multiple of invested capital, the total carry to the GP is $200 million and your share is $2 million. This typically vests and is paid out over a number of years, but can represent a substantial increase to your base compensation. If you consider a standard private equity fund life of five years, this equates to $400 thousand of additional compensation per year.
Beyond this additional compensation, carry is typically “topped up” each year with additional carry in existing or future funds. While this builds your unvested economic exposure to the fund, it does drastically increase the cost of switching jobs as you potentially leave substantial money on the table when you leave (although your new firm will in many times compensate you for the unvested carry you are leaving behind). There is also one significant additional bonus to carried interest compensation: it is generally taxed at the long-term capital gains tax rate instead of the ordinary income tax rate. This means that you will generally pay 15-20% taxes on this income, which is a significant advantage compared to the top marginal tax rate of almost 52% for New York City residents earning over $1 million annually (a difference of over $100 thousand in the example described above). While this carried interest tax break is often a target of politicians on both sides of the aisle, the private equity lobby has thus far been successful in protecting this substantial tax advantage for private equity professionals.
Private equity firms also often offer additional direct and indirect compensation that can increase your take-home pay, including inexpensive leverage to finance your commitments to the firm’s private equity funds, desirable no-fee co-investment opportunities, and additional carry for specific deals that you help source or execute.
Similar to private equity firms, hedge funds generally earn a 2% management fee plus 20% of profits. In hedge funds, compensation arrangements may vary, but at the junior level, typically consist only of a cash salary and a discretionary cash bonus. In many cases, the discretionary bonus makes up a larger portion of your total compensation than in investment banking or private equity and is highly dependent on your individual performance as well as the performance of the fund. Unlike private equity, where investments take 3-5 years or more to play out, hedge fund returns are evaluated on an annual basis and you thus may see a much quicker reward for generating profitable investment ideas (conversely, if your fund has a down year, you may receive little or no bonus).
This dynamic has positives and negatives. On the positive side, most of this compensation is paid out annually vs. carried interest that is paid out over many years (in some cases, firms may defer a portion of your discretionary bonus as an employee retention tool). Further, you can receive very outsized payouts (including bonuses well into the seven figures) if you work at a fund that generates strong performance. For example, many investment analysts working at long-short equity funds in 2020 and 2021 received very substantial payouts as a large number of firms generated outstanding annual returns of 30% or better. However, many of these funds were down in the challenging equity environment of 2022 and some hedge fund professionals saw annual compensation cut by 50% or more. Further, when a hedge fund loses money, it must return to its prior “high water mark” before it can start collecting incentive fees again (some firms may collect a lower share of profits during this time, or none at all). In the time period it takes to return to the high-water mark, the amount of money to pay out to the investment staff is smaller and likewise compensation typically decreases.
At certain hedge funds, you may receive direct profit-and-loss exposure as you develop more seniority. This means that you received a formulaic percentage of the total profit that you generate for the firm. For example, a PM may get 15% of the gross profit that they generate on their allocated capital. The portfolio manager will then use some of that to pay out his team and keep the rest. Typically, the largest hedge fund payouts (besides to those who own the firm) go to individuals with direct profit-and-loss exposure in high-performance years. Recently, there has also been a trend of certain funds such as Citadel and Millennium offering large guaranteed compensation packages (reportedly as high as $40 million or more) to portfolio managers as part of a broader war for talent in the hedge fund space.
As laid out above, there is high potential for (but certainly no guarantee of) large payouts in both hedge funds and private equity. Compensation should just be one of many factors you consider when evaluating what type of buy-side role is best for you (a topic for another article), but it is best to be equipped with all of the information when evaluating your options.
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