The Middle Market Is Hiring

There hasn't been much in the way of good news in terms of hiring and compensation in the private equity industry over the last couple of years. However, for the first time in a long time, there seems to be a light at the end of what's been a very long tunnel. The first positive change is that hiring seems to be picking up - at least anecdotally.

Evidence suggests that private equity hiring is increasing. For example, Pinnacle Group International, a firm that handles recruiting for private equity firms and investment banks, completed 22 placements during the first three quarters of 2012, that's up from 17 for all of 2011 and 25 for all of 2010. Additionally, the firm currently has 13 active searches in the works. What's more, mid- to small-market firms are doing most of the hiring. Of the searches that Pinnacle completed thus far this year, seven of them have been for middle-market buyout shops.

"Last year was a very tight market. This year has been better, and the middle-market firms have been a little more robust than they have been in the recent past. The fact of the matter is that it's harder to raise capital, and there are less management fees available, making it harder to hire people. However, I think this is the new norm," says Joseph Logan, a managing director and founder of Pinnacle, adding that, in general, there will be fewer people in the private equity business, as firms wind down old funds and aren't able to raise new funds.

"The growth, going forward, will come from smaller firms. They will emerge as the survivors. It's the $100 million to $500 million range that will survive, simply because there's more dealflow, and the overhead is not as significant, making it easier to run on a smaller scale," says Logan.

Recruiters agree that smaller is better these days, because the reality is that the smaller firms are outperforming their larger brethren. "Lower middle-market-focused growth equity and leveraged buyout firms have generated a significant amount of the returns in the private equity asset class in recent years," says Holly Davidson, a managing director with Jamesbeck Global Partners, an executive search firm specializing in investment management. "Although a few of the mega-firms are continuing to hire at senior levels, most of my clients in recent years have been middle market firms."

This isn't all that surprising considering that many of the mega-buyout shops have been forced to raise smaller funds over the last few years as a result of a pullback from limited partners (LPs). From January through the end of September, only 12 firms have raised more than $1 billion for new funds, compared with 45 to 60 firms raising over $1 billion per year between 2005 and 2008. Bain Capital, for example, is targeting only $6 billion for its upcoming vehicle, Bain Capital XI, which is down significantly from its $10.7 billion fund, Bain Capital X, which was raised in 2008. More painfully, the firm may be decreasing the carry fee that it charges LPs from 30 percent to 20 percent for Bain XI, which hasn't closed yet, according to a source familiar with the situation.

Naturally, smaller fund sizes equate to lower management fees, which means either less money for everyone, or less staff. Most funds have reacted by decreasing the size of their investment teams, which is mainly affecting junior staffers at the mega funds. Additionally, with less capital to put to work, they simply don't need as much staff to deploy the capital. "In my practice, I see a lot of mid- to senior-level investors looking for new homes as a result of firms getting smaller," says Davidson. "Unfortunately, there just aren't as many seats at the table these days as there were a few years ago, and it is often the principals and junior partners who get pushed out first to either make room for junior people coming up the ranks, or to maintain the economics of the senior partners."

Not surprisingly, many of those looking for work in private equity have focused their job search efforts on the smaller firms that are in the enviable position of being able to raise additional capital and add to their teams. Unfortunately, many candidates who think that transitioning to a smaller firm will be a layup are dismayed to find that their big-firm experience doesn't necessarily translate into success with smaller firms. Middle-market firms often value investment sourcing abilities, relationships, and specific sector knowledge over technical investment structuring and execution skills.

"Many of my mega-firm candidates need to make a shift in their thinking to realize that bigger doesn't necessarily always mean better, or best, in the current market. Middle-market firms couldn't care less about someone's ability to wring the last basis point out of a public bond financing," says Davidson.

In addition to the change in culture, the lower pay also takes some getting used to. While compensation numbers certainly vary based on a number of factors, Davidson estimates that a principal at a mid-market firm might earn $700,000 to over $1 million annually, excluding carry. At a mega fund, the numbers increase to $1 million to over $2 million, before carry.

According to Pinnacle, vice presidents at a large firm can bring in anywhere from about $400,000 to $700,000, with carry of between $2 million and $8 million over the life of the fund. For mid-sized funds the numbers drop considerably. A vice president at a mid-sized firm can bring home anywhere from $300,000 to $500,000 and anywhere from $1 million to $3 million in carry over the life of the fund, which is a significant decrease - but that's assuming that carry at the larger firms is worth anything these days.

During the boom years, several mega funds made investments that have compromised the value of their carry pools. Look no further than the $45 billion TXU Corp. deal completed by KKR, Goldman Sachs and TPG in 2007. KKR has already written down its $8 billion equity investment into TXU by 80 percent, according to The Wall Street Journal.

"Although people sometimes have a hard time getting their heads around the lower cash compensation levels, the reality is that the current value of the carry at many of the smaller firms often makes up for it," says Davidson.

Lastly, many of these candidates hail from New York, which isn't where the action is these days. They have to be willing to leave. "Many of these smaller firms have set up shop in secondary or tertiary markets, such as the West Coast, Midwest and Southeast - anywhere but New York. Yet, New York-based candidates are often reluctant to move, because they fear being away from the center of the action. But, in reality, there are more opportunities outside of New York right now, relative to the candidate pools. The folks who figure this out sooner rather than later, and are flexible, can often successfully make the shift to a smaller firm," says Davidson.

Chris Conti, a recruiter with Lancor, a global search firm that advises investors, board members and CEOs, concurs that the middle market is the brightest spot in private equity hiring these days, especially for the very successful funds. "Overall, fundraising is more difficult than it was. When you have a brand-name fund commence a fund raise, LPs clamor to get in, but you will still have a host of other funds that are struggling to close their funds," he says.

Conti says he has been seeing a lot of the hiring of operating partners, who are expected to have a wealth of knowledge in particular sectors. This has been an ongoing trend because generalist funds are no longer cutting it these days.

"Operating partners are not ex-bankers. Operating partners help transform businesses. We have seen a big push from firms that want to be able to tell their LPs a story about how they will transform companies. No one wants to hear about financial engineering. They want to know what capabilities you have to complete a turnaround," says Conti, who added that, while most firms are hiring operating partners on staff, some firms are hiring them as captive consultants to keep costs down. The portfolio companies pay these consultants when they are not in house.

"Everyone wants to have in-house operating partners, but when they understand the costs involved, some balk at the idea. There's less security in being the consultant, so you don't get the best candidates, because they are not a real member of the firm. Still, it's a dynamic that I see happening a lot and it's an okay strategy," says Conti.

Although there is job movement, competition among candidates is fierce. A search that used to take three months is now taking about five to complete. "Firms are able to be very particular and make sure they are hiring the right candidate," says Logan. "The standards are very high and, in many cases, it's taking longer for firms to vet the candidates."

Compensation

Overall, the compensation story is also a positive one. Although there are fewer jobs available in the larger market, the people who do remain employed seem to be making more money, after years of being flat or down. According to the Holt Private Equity Compensation Report, which surveys about 130 private equity firms, compensation levels are increasing at every level. Overall, base salaries from April 2011 through April 2012 were up 11.4 percent. When you add bonus numbers to the salary, compensation is up 16.6 percent over the year before.

Additionally, with the proliferation of exits taking place in the private equity market, carry distributions are up as well. "This is not 2007 or 2008, but it's picked up considerably," says Michael Holt, founder of Holt Private Equity Consultants.

For partners, salaries were flat, but carry boosted partners' total compensation by a whopping 56 percent, year over year. At a mid-sized firm, the median compensation for a managing general partner is $2.7 million, including carry distributions. At a large firm, that number is $6.1 million, including carry.

For non-partner investment managers, base salary has increased 7.1 percent and a whopping 27.1 percent, when you add in the bonus. When you add carry distributions into the mix, compensation actually decreased to 26 percent. The simple explanation for this is because non-partners get less carry as a percentage of their overall compensation.

"It's a little bit surprising how much compensation has jumped, based on what you read about regularly. The only way compensation can jump is if firms collect more fees, or have more exits. There haven't been more fees, but there have been a lot of exits - more than I would have anticipated," says Holt.

It's no surprise that after years of buying up companies during the credit bubble, many private equity firms are exiting their investments. They need to show wins on their balance sheets, as they gear up to raise new investment vehicles. Private equity firms are on pace to exit about $100 billion worth of capital by the end of 2012, according to the Pitchbook & Grant Thornton 2H 2012 Private Equity Exit Report.

According to Holt, with compensation up this year and last, the private equity industry might be on the verge of a positive trend. In 2009, total compensation across the board was down six percent; in 2010 it was down five percent. However, in 2011, it was up nine percent, and this year it's up 11 percent. "Hopefully, this is a start of an upward trend," says Holt.