Traditionally, the sector was viewed as a defensive play for investors who wanted stable dividends and no drama.

That is still true for the average company in the industry: it is more defensive than something like technology or financial institutions.

But over time, trends like market liberalization, deregulation, the shift to renewables, and the ESG religion “movement” have shaken up a sleepy sector.

We’ll get into these fun developments, but I want to start with the basic definitions:

Power & Utilities Investment Banking Defined

Power and Utilities Investment Banking Definition: In power/utilities IB, bankers advise companies that produce, transmit, and distribute electricity, natural gas, and water on raising debt and equity and completing mergers and acquisitions.

If you’re wondering about “transmission” vs. “distribution,” transmission is the part of the process where electricity is sent from power generation sites over long distances at high voltage levels to substations that are closer to people and businesses.

In the distribution process, the voltage is “stepped down” by transformers and sent to homes and businesses.

The “classification tree” is simple because this sector is quite narrow:

Of these verticals, electricity is easily the most important one; ~90% of publicly traded utility companies are involved in electricity in some way.

Power companies generate power (from fossil fuels, renewables, and nuclear) and sell it wholesale to utilities companies and other customers. They are often unregulated and do not focus on the transmission or distribution aspects.

Utility companies might generate their own power, but they could also buy some from power companies, and they focus on the transmission and distribution steps. They are also highly regulated and tend to be vertically integrated.

The power & utilities sector has lower volatility than others because electricity, gas, and water are necessities for modern life.

Companies tend to offer high, stable dividend yields, and they finance their massive capital expenditures primarily with debt, with the highest leverage ratios of any industry outside of financial institutions.

It’s also a highly localized industry, with many companies serving specific countries, states/provinces, and cities, and many operating “local monopolies.”

Different banks classify their power & utilities groups differently.

For example, Goldman Sachs puts it in “Natural Resources” or “Public Sector and Infrastructure,” JP Morgan puts it in “Energy,” it’s a separate group at Morgan Stanley, and there’s a “Power, Utilities & Renewables” group at Bank of America.

While there is overlap between power & utilities, infrastructure, oil & gas, and renewables, the industry structure and drivers are quite different, so we’re treating it as a separate group.

Recruiting into Power & Utilities Investment Banking

There’s nothing special to note here because power & utilities investment banking is a moderately specialized group (at best).

You have a small advantage if you have a relevant background, such as experience at a power or infrastructure company or in the public sector, but it won’t make a night-and-day difference.

Most large banks have strong power & utilities groups, so you can’t go wrong with any of them.

If you’re recruiting outside the large banks, there are many boutiques in this sector, but they tend to focus on high-growth renewables companies, so it’s not quite the same industry.

Overall, though, there are fewer industry-focused independent/boutique firms than in sectors like technology or healthcare.

That means that power & utilities is not the best sector to target if you’re trying to get into IB from “off the beaten path.”

What Does an Analyst or Associate in Power & Utilities Investment Banking Do?

The most common deal types in this group are debt issuances and asset acquisitions and divestitures.

To get a sense of this, take a look at the number of debt issuances by NextEra Energy (Florida Power & Electric) in less than one year (click the image to view a larger version):

Investors do not view most power/utility firms as “growth companies,” so initial public offerings (IPOs) are fairly rare.

Follow-on equity offerings occur, but they’re usually motivated by concerns such as complying with a debt / total capital ratio set by the government.

Larger M&A deals also happen, but they’re less common than in other sectors because of factors like regulation, which may limit companies’ expansion into new regions.

Asset acquisitions are very common because they’re one of the few growth strategies available to these companies.

Regulators might block large corporate-to-corporate M&A deals and might not allow a company to raise its rates, but they’re less likely to block the acquisition of a single power plant or a smaller transmission network.

Also, the push for renewables has led to many firms divesting oil/gas/coal assets and acquiring ones with less of a carbon footprint.

Leveraged buyouts of entire power & utility companies are not common for similar reasons (regulations, infamous failure stories like TXU, etc.); asset-level deals are more frequent.

Finally, except for one-off scenarios like the Pacific Gas & Electric bankruptcy, restructuring deals are not common in this sector.

If they were, lenders wouldn’t accept 50% debt / total capital ratios.

Power & Utilities Trends and Drivers

Some of the most important drivers include:

• Economic Growth – Strong economic growth tends to result in higher electricity usage, but people don’t necessarily use more water or gas when growth is higher. Utilities often benefit when economic growth weakens because a recession hurts them less than other industries.
• Demographics – Population growth and demographics are the most important long-term drivers that affect utility demand. For example, is the birth rate rising or falling? What about the new household formation rate? Are people moving to areas where more or less electricity, gas, and water will be required?
• Interest Rates and Monetary Policy – Loose monetary policy, such as lower interest rates and expansion of the money supply, tends to benefit utility companies because they can finance their capital expenditures at lower rates. However, when interest rates rise, this financing becomes more expensive, and utilities’ dividend yields become less attractive relative to higher-yielding bonds.
• Inflation – Inflation makes fuel and other operating costs more expensive, but regulatory mechanisms sometimes allow utilities to pass on rising costs to customers. Sometimes their “authorized revenue” is even linked to the inflation rate. So, the impact of inflation depends on the regulatory scheme and whether it is expected or unexpected. Unregulated power companies often benefit from inflation because they can react and increase their prices more quickly.
• Technological Change (Shift from Oil/Gas/Coal to Nuclear and Renewables) – Government mandates, tax credits, and subsidies have shifted the typical fuel sources for both power and utility companies, and the effects vary widely based on investor sentiment and the policies supporting these changes. It’s safe to say that they have encouraged more deal activity.
• Regulation – This affects everything from firms’ capital structures to their revenue, margins, and favored fuel sources, so the impact could be minimal or very large in either direction, depending on what the government changes.

Power & Utilities Overview by Vertical

Electric utilities are the biggest segment, so we’ll focus on them here.

Water is the smallest, so we’ll group water and gas utilities and discuss multi-utilities and power firms separately.

There are very few “pure-play” firms in any of these categories because most firms do a bit of everything.

Electric Utilities

Representative Large-Cap Public Companies: Fortum (Finland/Europe), Enel (Italy), Electricité de France, Korea Electric Power Corporation, Iberdrola (Spain), Tokyo Electric Power Company, EnBW Energie Baden-Württemberg (Germany), Exelon, NRG Energy, Endesa (Spain/Portugal), and Duke Energy.

The biggest electric utility companies tend to have unregulated power generation assets that span multiple states/provinces or even countries (ex: Duke Energy in the U.S. or Fortum/Uniper in Europe).

The smaller players usually operate as vertically integrated “local monopolies” and more closely resemble the traditional view of the utilities sector.

Since electricity cannot be stored or controlled easily but can travel great distances almost instantly, electric utility companies need delivery systems with significant spare capacity to deal with rapid demand fluctuations.

They divide demand into the “base load,” “intermediate load,” and “peak load,” and they manage their networks based on the load factor (peak load minus average load) and the load composition (the weights of different customers, such as residential vs. industry).

These load metrics matter because companies tend to use different fuel sources to meet each type of demand.

The ideal “base load” fuel sources include those with high fixed costs and low variable costs, such as coal, nuclear, and hydroelectric power.

For intermediate and peak loads, companies prefer sources such as oil and natural gas, with lower fixed costs and higher variable costs (since these loads comprise much less time).

Wind and solar might also be used in the intermediate range if they’re available.

Regulated utilities follow the cost of service rules, in which the government sets allowable electricity rates so that utilities can cover their expenses and offer a “reasonable” return for investors.

Lazard’s presentation to the Tennessee Valley Authority on its possible privatization sums up the mechanics quite well on slide 118 (click the image to view a larger version):

All regulated utilities have a “Rate Base,” which represents the total value of their power plants, transmission lines, distributions, and other infrastructure (Net PP&E on the Balance Sheet with some adjustments, such as deductions for unregulated power assets in regulated regions).

Regulators then set the allowed Debt / Total Capital ratio that can fund these assets and the authorized Return on Equity (ROE).

For example, let’s say the company’s Rate Base is $1,000, as in the Lazard example above.

The allowed Debt / Total Capital Ratio is 50%, so the company has $500 of Equity and $500 of Debt to fund its assets (ignoring non-PP&E assets for simplicity).

(Note that the $500 of Equity here refers to the book value of Equity on the Balance Sheet or the Statement of Owner’s Equity, not the market value.)

The Authorized ROE is 10%, so the allowable Net Income is $500 * 10% = $50 (you focus on REO for power/utilities rather than “total capital metrics” like ROIC).

At a 25% corporate tax rate, its Pre-Tax Income is $50 / (1 – 25%) = ~$67.

Regulators then work backward and add the standard Income Statement expenses to determine the Base Revenue Requirement.

Maybe the company’s Pre-Tax Cost of Debt is 5%, so the lenders earn $500 * 5% = $25 in interest.

The company also has $200 in Operating & Maintenance Expenses and $40 in Depreciation.

Adding those up, $67 in Pre-Tax Income + $25 in Interest + $200 in O&M + $40 in Depreciation = $332 for the Base Revenue Requirement.

If the company sells 4 GWh of energy, its “allowable rate” is $0.083 per kWh.

You can already see one major problem with this method: what if the company’s costs suddenly change due to inflation, a fuel shortage, or high demand?

To deal with this issue, some regulators allow “enhanced cost recovery mechanisms” that allow utilities to increase their rates without formally requesting a rate increase.

Another issue is regulatory lag, as power plants and infrastructure can take years or decades to develop – and while that is happening, utility firms may not be allowed to earn more.

Some regulators allow “Construction Work in Progress” to be counted in a firm’s Rate Base to deal with that.

Because of cost-of-service rules, regulated utilities have 3 main growth options:

1. Cut expenses and boost the actual ROE as close to the Authorized ROE as possible.
2. Ask the regulators to increase their Authorized ROE, reduce regulatory lag, or permit a different capital structure.
3. Develop or acquire more power plants and transmission/distribution infrastructure, i.e., increase the Rate Base.

These factors explain why all power & utilities investor presentations have references to the company’s “strong projected Rate Base growth”:

One Final Note: The terminology and calculations differ by region, but the principles are always the same.

For example, in Australia, the Rate Base is called the “Regulated and Contracted Asset Base” (RCAB), but it’s the same idea:

Independent Power Producers (IPPs) or Non-Utility Generators (NUGs)

Representative Large-Cap Public Companies: Uniper (Germany/Europe), Huaneng Power International, RWE Aktiengesellschaft (Germany/Europe), GD Power Development (China), Edison (Italy), NTPC (India), Datang International Power Generation (China), Huadian Power (China), Vistra (U.S.), AES (U.S.), Drax (U.K.), Enel Generación Chile, and Meridian Energy (New Zealand).

Many of these companies are subsidiaries of larger utility/power companies, and most of the biggest ones operate in China.

Power generation is the most complex and expensive part of the electricity delivery system, which explains why many companies doing it operate as unregulated entities (higher prices).

When analyzing these companies, the split of fuel sources and the availability of each one matter a lot:

And apologies to the faithful ESG warriors out there, but each fuel source, including renewables, has its advantages and disadvantages.

For example, coal power plants are expensive, emit the most carbon, and require high upfront spending for their infrastructure, but their variable costs are low since coal is cheap.

Gas plants are smaller and cheaper to build, and they emit less carbon, but their variable costs are higher – so gas tends to be used for intermediate and peak demand.

Renewables like solar and wind also have higher upfront capital costs because the power generation sites are far from populated areas, which means more infrastructure.

And yes, they do not emit carbon once operational, but they’re also less dependable until storage technology gets much better.

Since fuel is the biggest expense for power companies, one of the most important metrics is the gross utility margin, or the revenue generated by the sale of electricity minus the fuel costs.

This margin goes by different names based on the fuel source as well (“spark spread” in natural gas, “dark spread” in coal, and “quark spread” for nuclear).

Other important metrics include the dispatch curve (power supplied vs. the variable costs of power generation), the capacity and utilization of individual plants, and the reserve margin (total generation capacity minus peak demand).

Finally, you need to understand the basic units that allow you to calculate revenue.

For example, if a solar installation has a 20 MW capacity, a 15% net capacity factor (due to weather, the day/night cycle, peak power periods, etc.), and power prices are currently $50 per MWh:

• Capacity = 20 MW
• Annual Energy Production = 20 MW * 24 hours * 365 days * 15% = 26,280 MWh
• Annual Revenue = 26,280 MWh * $50 per MWh = $1.3 million

In the projections, you’d apply an escalation factor to the power prices and operating expenses and a “degradation factor” to the capacity because of wear and tear.

Gas & Water Utilities

Representative Large-Cap Public Companies: Naturgy Energy (Spain/Latin America), Korea Gas, ENN Natural (China), Tokyo Gas, AltaGas (Canada), Sabesp (Brazil), American Water Works, Southwest Gas Holdings, Beijing Enterprises Water Group, and Rubis (France/Europe).

Some of the key drivers and metrics for electric utilities are also important here.

For example, regulated water and gas companies focus heavily on their Rate Base, capital structures, and CapEx, often using these factors to justify deals:

The key differences are as follows:

1. There are very few publicly traded water companies because in many countries, such as the U.S., 90% of water and waste management is managed by municipal governments. Most of the biggest water companies are part of the larger, diversified companies in the Multi-Utilities segment (see below).
2. In the U.S., many gas utilities operate as regional monopolies called “Local Distribution Companies” (LDCs) that serve specific geographies. Multi-state and multi-country companies with some unregulated assets are less common than in electric utilities.

Gas and water can be stored more easily than electricity, so the distribution networks don’t need as many special features.

That makes the companies operationally simpler, at least if you focus on pure-play firms.

Multi-Utilities

Representative Large-Cap Public Companies: E.ON (Europe), ENGIE (France), Veolia Environnement (France), National Grid (U.K.), Centrica (U.K.), A2A (Italy), DTE Energy (U.S.), Hera (Italy), Dominion Energy (U.S.), Consolidated Edison (U.S.), Sempra (U.S.), Abu Dhabi National Energy Company, and AGL Energy (Australia).

Many companies in this sector do a bit of everything because there’s significant overlap between different types of utilities or, in banker speak, “synergy opportunities.”

For example, gas and electric utilities both need to install meters to measure customers’ usage and bill them, so why not combine the functions into a single device that one technician can install?

Also, since rising fuel prices represent a major risk factor for both, an electric company that relies on natural gas might be able to hedge some of the risk by acquiring a gas utility and selling gas when prices rise.

When analyzing these companies, you need to divide them into their respective segments and consider which ones are regulated vs. unregulated.

The Cost of Capital, Rate Base, Authorized ROE, and even the Debt and Equity percentages may differ for different segments:

Power & Utilities Accounting, Valuation, and Financial Modeling

There are some differences on the technical side, but this group is not nearly as specialized as real estate, FIG, or oil & gas.

Most operational/projection differences relate to the concepts already discussed above, such as the Rate Base, Authorized ROE, and Capacity/Production calculations (something like Return on Assets (ROA) could also come up, but is much less important than ROE).

As a result of these points, you often make CapEx and the Rate Base the key drivers and then “back into” revenue based on allowed price increases.

It is 100% possible to use standard valuation multiples, such as P / E and TEV / EBITDA, to value power/utility companies, and you’ll see many examples in the Fairness Opinions below.

However, there are a few industry-specific or specialized multiples as well:

• Enterprise Value / Rate Base (TEV / RB): The Rate Base represents all investors in the company and determines its allowable revenue and earnings, so it’s perfectly valid to turn it into a valuation multiple.
• Equity Value / Book Value (P / BV) or Equity Value / Tangible Book Value (P / TBV): Since Book Value, or Common Shareholders’ Equity, is a percentage of the Rate Base for regulated utilities, you can also split off this equity portion and turn it into a valuation multiple. As with banks, utilities with higher ROEs tend to trade at higher P / BV multiples.
• Enterprise Value / Capacity ($ per MW): Finally, for power generation companies, capacity is the key top-line driver that determines revenue. It affects all investors, so TEV / Capacity multiples are sometimes used.

You can see an example of an industry-specific multiple (EV / RCAB in Australia) if you look at APA’s presentation used in an attempt to outbid Brookfield for AusNet:

The Sum of the Parts Valuation is a very important methodology in this sector, and you see it in all types of valuations and Fairness Opinions because so many companies operate across multiple segments.

For example, take a look at these valuations for a complex reorganization of Enel Group in Chile:

Example Valuations, Pitch Books, Fairness Opinions, and Investor Presentations

Since many of these companies and deals involve multiple verticals, I’m not splitting up this list like that.

Instead, I’ll make a short note of the deal type and banks involved.

You can find plenty of valuation football fields in the links below:

• Tennessee Valley Authority (TVA) – Potential Privatization or Spinoff (Lazard)
  • Strategic Assessment Presentation – This is the most detailed presentation you will find in this sector (139 slides!).
  • Article with Background Information
• Exelon / Constellation Energy – Spinoff (MS and Centerview)
  • Investor Presentation
• National Grid / PPL – Divestiture of U.K. Utility Business (Barclays, GS, and JPM)
  • PPL Investor Presentation
• Brookfield and Other Investors / AusNet (Adara Partners, Citi, and BAML) – Heavily contested utilities deal in Australia
  • APA Group’s Presentation on its Superior Bid for AusNet
  • Case Study from Adara Partners on the Deal Timeline
  • Brookfield Presentation (Note on pg. 13)
• JPM Infrastructure Investments / South Jersey Industries (Centerview and BAML) – Primarily a natural gas utility
  • BAML – Fairness Opinion
  • Earnings Presentation with Note About the Deal
• Aqua America (nka: Essential Utilities) / PNG Companies (GS, Moelis, RBC, and MS) – A water utility acquiring a gas utility to diversify
  • Investor Presentation
• Algonquin Power & Utilities (BAML and Wells Fargo as joint bookrunners) – $750 million in Subordinated Notes
  • Prospectus
• Veolia Environnement / Suez (BAML, Credit Agricole, HSBC, Messier Maris, MS, Perella Weinerg, and FINEXSI) – Huge merger in France in the waster/wastewater management space
  • Investor Presentation
  • FINEXSI – Fairness Opinion
  • Company Propaganda to Support the Merger
• Pacific Gas & Electric (PG&E) (JPM, BAML, Barclays, and Citi) – Bankruptcy and Debtor-in-Possession Financing
  • Lender Presentation
  • Fitch Credit Rating
  • Court Motion and Sources & Uses for Deal
• Enel Chile / Enel Generación (Banchile, Econsult, LarrainVial, and Asset Chile) – This was a complicated reorganization deal with a combined merger and public tender offer
  • Series of Fairness Opinions from Banks
  • Various Bank Presentations
  • Roadshow Presentation
• Avangrid / PNM Resources (BNP, MS, and Evercore) – Power generation and electric utility merger
  • Investor Presentation
  • Evercore – Fairness Opinion

Power & Utilities Investment Banking League Tables: The Top Firms

It’s tricky to determine the “top banks” in this sector because many deals are asset acquisitions that do not show up in the league tables since the deal sizes are undisclosed.

Also, there are classification issues because power & utilities investment banking overlaps with other groups such as renewables and natural resources.

However, if you ignore all that and focus on the league tables by deal value, you’ll see names like Bank of America, JP Morgan, RBC, Goldman Sachs, Morgan Stanley, and Barclays as leaders.

Some of these focus on larger corporate-level deals (GS), others are stronger in conventional energy (Barclays), and others are stronger in renewables (BAML).

Citi is also quite active in the sector but tends to work on asset-level deals more than corporate ones.

Among the elite boutique banks, Evercore and Lazard are quite active, as are Moelis, Centerview, Guggenheim, and Robey Warshaw (more of an “up and coming” elite boutique?).

Some of the Big 5 Canadian banks are also well-represented on these deals, and “good but not quite elite boutique firms” such as PJ Solomon also show up.

There’s also Nomura Greentech, which is very active but only on renewable deals.

Similarly, most boutique banks in the space focus on renewables: Marathon, CohnReznick, Onpeak, and Green Giraffe are some examples.

Power & Utilities Investment Banking Exit Opportunities

Contrary to what you might think by reading this article, the exit opportunities out of power & utilities investment banking are quite broad.

Yes, you have an advantage if you aim for something highly relevant, such as an infrastructure private equity firm or corporate development at a power company, but you’re not precluded from more generalist opportunities.

You’re probably not a great candidate for venture capital and growth equity roles except for those focusing on the renewables sector, but the other standard opportunities are all feasible (hedge funds, private equity, corporate development, etc.).

On the other extreme, you probably wouldn’t be a great candidate for distressed investing roles because most debt issuances in this sector are investment-grade.

For Further Reading

Some good information sources include:

• News: Utility Dive, S&P Energy News and Research, Power Mag, Energy & Utilities, Transmission & Distribution World Magazine, and FT Utilities
• Industry Research: Deloitte, KPMG, PricewaterhouseCoopers, and Ernst & Young
• Books: Fisher Investments on Utilities, Principles of Utility Corporate Finance, and a metric ton of books on renewables

Is the Power & Utilities Investment Banking Group Right for You?

So, you get solid exposure to many debt, M&A, and asset deals, fairly broad exit opportunities, and you can specialize without becoming overly specialized.

What’s the downside of power & utilities investment banking?

Some would say that it’s “boring,” but with all the tech trends, policy changes, and ESG craze, I don’t think that’s necessarily true.

The biggest real downside is that you often work on the same types of deals repeatedly – even in different verticals – so there is less variety than in a healthcare or consumer/retail group.

But if you don’t mind that, or you can find a group with more varied deal types, this might not be a downside at all.

Just remember to reduce your carbon emissions before applying, or your ESG score might stop you from getting a job – even if your GPA is fine.

Want more?

You might be interested in:

• Investment banking product groups
• Investment banking industry groups
• Industrials Investment Banking: The Complete Guide

The post Power & Utilities Investment Banking: How to Turn Yourself into an Electrified ESG Warrior appeared first on Mergers & Inquisitions.

So, you won equity research interviews by networking aggressively…

You presented 2-3 well-researched stock pitches and passed your interviews…

…and despite MiFID II and rumors of the industry’s demise, research teams still exist at banks.

What happens when you start your equity research career, how much will you work, and what exit options will you get?

All good questions – so we’ll answer all of those and more here:

What To Expect In An Equity Research Job

Similar to other public-markets roles, you might arrive at work a couple hours before the market opens. In New York, that means “around 8:00 AM.”

Once you arrive at your desk, you’ll spend some time catching up on emails from traders and salespeople, reading the news, and monitoring overnight market developments.

The rest of the day is a mix of keeping things up to date (e.g., financial models), researching companies, and finding new companies to initiate coverage on.

The best and most experienced Associates also interact with clients and set up management meetings between companies and buy-side firms, and these are the real moneymakers for equity research careers in the post-MiFID II environment.

Doing the work required to initiate coverage and building the initial model can take months, so teams need to balance that with other tasks, such as client summits and conferences.

Professionals in equity research careers are best-known for insightful reports, but these reports do not necessarily take up the bulk of staff time.

That said, if the group is working on a detailed “thought piece” that reaches counter-consensus conclusions, that can consume a lot of time and effort. But it can also be worth it if it results in more viewership and client interactions.

Your time allocation during the day depends heavily on the industry you’re covering and how the Research Analyst (read: your boss) likes to run things.

In some teams, Associates spend 75% of their time modeling, but in others, it might be closer to 25% – and that percentage often changes over time.

Often, junior team members get tasked with modeling or grunt work, especially in larger teams, and senior members spend more time talking to investors and companies.

In equity research internships, you’ll assist the full-timers with data gathering, industry research, model updates, and more.

Equity Research Hours

If it’s a normal day, you might leave around 8:00 PM, which means ~12-hour workdays.

However, hours get significantly worse during earnings season, which happens once per quarter, and during industry conferences.

Unforeseen news events and developments, such as regulatory changes, M&A deals, earnings pre-announcements, or Amazon entering your space, can also make the hours worse.

Earnings season is busy because you have to update all your models and issue new reports with new estimates, and industry conferences are busy periods because you run around meeting people during the day and then do your actual work at night.

In both those periods, the 12-hour days can easily turn into 16-hour+ days, so the job will approach investment banking hours.

If you experience consistent mid-intensity stress levels in banking, equity research careers give you low-intensity stress most of the time, with occasional spikes to high stress.

As with any other public-markets roles, your schedule can be tough if your time zone doesn’t match the time zone of the major financial center in your region.

For example, if you’re on the West Coast of the U.S., you can look forward to waking up at 4 AM and arriving at the office by 5 AM each day.

Finally, the hours can get worse as you advance because Analysts have to travel and interact with clients while still assuming responsibility for published research.

Equity Research Careers: Example Reports and Other Deliverables

The published reports represent the “deliverables” that most people associate with equity research.

We linked to a few examples in Part 1 of this series on equity research recruiting:

• Morgan Stanley – Update on Lululemon Athletica
• Morgan Stanley – Initiating Coverage on Citizens Financial Group
• RBC – Initiating Coverage on Waddell & Reed Financial
• Lehman Brothers – REIT Sector Overview
• Lehman Brothers – Initiating Coverage on CBS Corp

You can divide these reports into three broad categories:

• Initial Opinion / Initiation of Coverage (IOC): This one is the first report ever published by the team on a specific company. It tends to be long (dozens of pages or more), and it has a lot of industry/market data, detailed rationale for the projections, information on competitors, the company’s valuation, and more.
• Industry Overview / Primer: This type of report also tends to be long (dozens of pages) because it covers an entire industry, such as U.S.-based pharmaceutical companies or European ground transportation companies (read: trucking). There will be sections on trends and key drivers/metrics, risk factors, legislation, and overall valuation levels, followed by shorter sections on specific companies.
• Company Note: This report is shorter (5-10 pages) and is issued when a company reports earnings, hosts an investor day, presents at a conference, or makes an announcement that impacts its strategy, such as an acquisition or the launch of a key product.

The “Initiation of Coverage” and “Industry Overview” reports consume a lot of resources, so teams must weigh the benefits carefully before deciding to invest the time and effort in creating them.

A typical research team covers around a dozen companies, so if your sector is “Large-Cap European Airlines,” your coverage list might include the Lufthansa Group, Ryanair, IAG (British Airways, Iberia, and others), Air France-KLM, EasyJet, Turkish Airlines, Aeroflot Group, Norwegian Air, Wizz Air, Pegasus, Alitalia, and TAP Air Portugal.

You focus on names that buy-side investors are interested in – in Europe, they’re paying you directly for the research, and in other regions, they’re making trades through your bank and generating commissions, and you encourage those trades with research.

Some boutique and middle-market firms focus on lesser-known names because they can add more value when they’re not team #37 covering the same company.

Your team might decide to initiate coverage on a new company when a firm you cover is acquired or gets de-listed, or because the company’s strategy or business model changes, or because your team gets additional headcount.

When that happens, you can expect to do a deep dive on that single company and its sub-industry for weeks or months until you have a detailed projection model and qualitative research to back up your assumptions.

The Equity Research Hierarchy and Promotions

In research, the most senior team member is the “Analyst,” and below that are the “Research Associates.”

Each team usually has one Analyst and 2-3 Associates, with one Associate for every 7-10 names under coverage.

This system is a bit confusing because “Analyst” and “Associate” are just the titles used on published reports.

Internally, the hierarchy is still similar to the one in the investment banking career path, where you advance from Associate to VP to Senior VP/Director to MD.

The difference is that Analysts can be different levels: VP-level Analysts vs. MD-level Analysts, for example.

The total headcount across equity research at all banks in the U.S. is an order of magnitude smaller than the investment banking headcount: Hundreds of professionals rather than thousands.

That smaller industry size and the historically lower turnover mean that it’s often difficult to advance in equity research careers by staying at the same bank.

Sometimes you may get lucky and find an opportunity if your Analyst suddenly leaves, but you’re more likely to get promoted by joining a different bank.

To advance, you must build a reputation instead of burying yourself in Excel all day. No one cares how fancy your model is – they care how good your insights are.

Many Associates struggle to move up because they don’t take the time to get to know management teams and institutional investors.

If you don’t perform well enough to advance, you won’t necessarily be fired dramatically; research professionals are cheaper than bankers, and there’s no fixed 2-year or 3-year program.

That said, it is not unheard of for entire research verticals to be eliminated during cost-cutting season.

At the junior level, people tend to stick around for 2-4 years before moving to another firm or leaving their equity research careers behind.

Equity Research Salary and Bonus Levels

As of 2018, Associates in major financial centers tend to earn between $125K and $200K USD in total compensation, with about 75% of that from their base salaries.

Post-MBA and graduate-level hires earn in the middle-to-high-end of that range, and possibly slightly above it.

As with investment banking compensation, you’ll probably earn below this range in London for a variety of reasons (GBP/USD, Brexit, MiFID II, pay is almost always lower in Europe, etc.).

VP-level professionals earn between $200K and $300K, again with 75%+ from their base salaries.

However, at smaller banks, VPs could earn below this range – something closer to the Associate compensation range is possible at the lower end.

Directors might earn between $300K and $600K, with 50-75%+ of that in base salary. At this level, the year-end bonus starts to make a huge impact on total compensation.

Finally, MDs could earn between $500K and $1 million, with base salaries in the $250K – $600K range.

Back in the dot-com boom of the late 1990s, some Analysts earned $10 million+, but these days, it’s a great outcome if an MD-level Analyst clears $1 million.

To earn in the low millions (say, $1.0 – $2.5 million), you’d likely have to be one of the top few Institutional Investor-ranked Analysts.

With MiFID II, these numbers will almost certainly fall – especially in Europe.

Equity research careers have always paid less than ones in investment banking, and that difference is likely to widen over time.

Historically, bonuses were based on 1) Analyst rankings such as the Institutional Investor Poll (II) Greenwich Poll; 2) the performance of Buy/Hold/Sell calls; and 3) revenue indirectly generated via trading commissions and investment banking fees (e.g. from companies going public or public companies issuing follow-on offerings through the bank).

With MiFID II, the basis of compensation will presumably shift to the amounts buy-side firms are spending directly on research.

The research reports themselves are not necessarily that expensive, but interactions and management meetings, non-deal roadshows, and conferences add up, and in some cases, buy-side firms end up spending more and consuming less.

Buy-side firms spend this money because many of their professionals cover breadth rather than depth, and sell-side Analysts might know specific companies in more detail.

Research compensation is likely to become more lopsided, with the top-ranked groups garnering the bulk of the fees and lower-ranked firms fighting over the scraps.

Equity Research Exit Opportunities

The bad news is that it is almost impossible to break into private equity directly from equity research.

Yes, a few people have done it over the years, but it’s far easier to transfer into investment banking first if you want to go that route.

You do not work on mergers, acquisitions, or leveraged buyouts in equity research, which makes your skill set not-so-useful for PE roles.

It’s far more common to move to hedge funds or asset management firms since there’s a direct skill set overlap – you analyze public securities and make investment recommendations in each one.

Within that category, long/short equity funds are the most natural fit for equity research professionals, while global macro funds are the worst fit because you work on the “micro” level in most equity research groups.

Other types, such as merger arbitrage and event-driven funds, could be a good fit depending on the sector you covered and the importance of deals, news, and events in that sector.

For more about this topic, please see our articles on hedge fund careers and private equity vs hedge funds.

Another option is to start your own fund eventually, which we cover in our “How to Start a Hedge Fund” article – but the key word there is “eventually” since you won’t be able to do this directly out of an ER role.

You could also move into the corporate finance career path at normal companies, investor relations, or potentially even corporate development – your industry expertise may compensate for less deal knowledge there.

Some professionals also leave their equity research careers and move into corporate strategy because their coverage and analysis of companies is typically higher-level, which fits right in with strategy.

In those roles, you might also be in charge of competitive intelligence, monitoring your firm’s peer group, and publishing internal reports.

Some research professionals also decide to attend business school, and if they do, they’re viewed similarly to other high-performing financial professionals.

One challenge is that it can be harder to get solid recommendations in equity research because team sizes are smaller, and the Analyst calls all the shots.

So, if your Analyst relationship isn’t great, you may have to request recommendations from other groups or people outside the firm.

It’s not uncommon to ask another Associate, a salesperson, or a trader for a recommendation for this reason.

Are Equity Research Careers Still Worthwhile?

Going back to that question we posed in Part 1, our most frequent query about equity research careers goes something like this:

“Everyone says the industry is dying! Should I still go into it? Won’t the new regulations, falling commissions, and passive investing destroy everything?”

And the answer remains the same: The industry won’t go away overnight, but it is less appealing than it once was.

However, that matters a lot more for Senior Analysts with 10+ years of experience whose business models are being pulled out from under them.

If you’re at the undergrad or MBA level, you could still make a solid case for working in equity research for a few years and then using the skill set to move into another industry.

You’ll do more interesting work than in investment banking.

You’ll have more of a life, with saner, more predictable hours and occasional stressful periods.

You’ll build a solid network of buy-side professionals and company managers.

And you might even be able to sneak in through the side door – like an undervalued stock.

• Equity Research Recruiting – Part 1
• Equity Research Careers – Part 2

Want more?

You might be interested in:

• Biotech Equity Research: The Best Escape Plan from Medicine or Academia?
• The Equity Research Analyst Career Path: The Best Escape from a Ph.D. Program, or a Pathway into the Abyss?
• Fixed Income Research: The Overlooked Younger Brother of Equity Research?

–

Numi Advisory has provided career coaching, mock interviews, and resume reviews to over 600 clients seeking careers in equity research, private equity, investment management, and hedge funds. With extensive firsthand experience in these fields, Numi offers unparalleled insights on how to ace your interviews and excel on the job.

Numi customizes solutions to each client’s unique background and career aspirations and helps them find the path of least resistance toward securing their dream careers. He has helped place over 150 candidates in leading buy-side and sell-side jobs. For more information on career services and client testimonials, please contact numi.advisory@gmail.com, or visit Numi’s LinkedIn page.

The post Equity Research Careers: A Day in the Life, Advancement, Compensation, and Exit Opportunities appeared first on Mergers & Inquisitions.

Not all these articles all bad; some have a few decent tips and tricks.

But most guides fail to disclose one important point: Unless you have exactly the right background, it will be an uphill battle to break into private equity.

Still, you’re probably obsessed with working at KKR or Blackstone, so I’ll explain the entire process from beginning to end – including why it’s so ridiculously hard to break in:

How to Get Into Private Equity: Your Brutal Reality Check

Whenever I write about this topic, we tend to get questions from non-traditional candidates who believe that their backgrounds will appeal to private equity firms. For example:

• Science or engineering PhDs
• Post-MBA investment banking associates
• Corporate lawyers
• World of Warcraft gold farmers
• Male strippers
• Mid-career corporate finance professionals

Unfortunately, you have a very low chance of getting into private equity from these fields.

Overwhelmingly, private equity firms hire:

• Investment Banking Analysts at bulge bracket and elite boutique banks, as well as a few In-Between-a-Banks

• Undergraduates for junior-level roles, such as Private Equity Analysts (common in some markets, such as Brazil and Portugal, and increasingly common at mega-funds and upper-middle-market funds in developed markets)

• Professionals who already work in PE at different firms

• And smaller firms also hire IB Analysts at middle market and boutique banks.

It is possible to get in if you’re not in one of these categories, but it is not probable.

If you get into the industry and you’re not in one of these categories, then:

• You’re outside the U.S. / U.K., in a market where it’s more feasible for non-bankers to get in. Examples include Russia, India, Central & Eastern Europe, and Portugal.

• Or you’re in a closely related field where you work on transactions – examples include Big 4 valuation/advisory, direct lending, corporate development, and real estate. Consulting might qualify, but it’s still a challenge in major markets.

• Or you’re aiming for new or smaller funds that do not have highly structured recruiting processes.

I’m not trying to scare you away, but I do want to be realistic about your chances.

What If You’re Not in Those Categories and You Still Want to Know How to Get Into Private Equity?

My top recommendations would be:

• Go for real estate roles, such as commercial real estate brokerage or real estate lending, and leverage those to move into real estate private equity.

• Consider corporate development careers instead of PE, especially if you’ve had prior banking experience. The pay is lower, but the work environment is better, you can have a life, and the work is similar. And you can potentially move into PE or IB from here.

• Consider the nuclear option: Attend a top business school, do investment banking, and then pursue exit opportunities as a post-MBA Associate. Not easy, but possible.

• Wait until you become much more senior and join a PE firm as an Operating Partner or Consultant. The private equity value creation team is not the same as working on deals directly, but you can still impress vapid socialites by saying “you’re in private equity

For the rest of this article, I’ll assume that you’re in investment banking or a related transactional role, or that you’re in a market where non-bankers can get in.

Private Equity Recruiting: On-Cycle and Off-Cycle Processes

First, note that there both on-cycle and off-cycle recruitment processes; they differ in timing, steps, interviews, and hiring criteria.

The On-Cycle Recruitment Process

The on-cycle process is the one that begins for Analysts at bulge bracket and elite boutique banks in New York within a few months of their start date.

It starts and finishes very quickly, with the mega-funds interviewing everyone and handing out offers in a single weekend, and middle-market firms finishing after that.

Headhunters have a ridiculous amount of power in this process, and if they don’t like you, you’re screwed.

If you finish the on-cycle process and win a job offer, the position will start in 1.5 – 2.0 years.

So, you may interview in December of 20X1, keep working in banking, and then begin the PE role in July or August of 20X3.

The Off-Cycle Recruitment Process

The off-cycle recruitment process is for everything else:

• roles outside of New York
• roles in other countries
• roles at smaller firms
• roles available to anyone not working at an investment bank

In the off-cycle process, you start working immediately after winning the offer, which makes a lot more sense than waiting for 1.5 – 2.0 years.

Off-cycle processes tend to take more time – months rather than weeks or days – and interviewers evaluate your “fit” and critical thinking abilities in more depth.

Case studies and financial modeling tests in on-cycle processes tend to be time-pressured ones where you have to get the answer as quickly as possible, while the ones in off-cycle processes require more thought and a real investment thesis.

In some places, the typical process is in between these extremes.

For example, many headhunters in London begin contacting candidates a bit later than in NY, and they present both “start immediately” and “interview in advance” opportunities.

Larger London funds stick to more of a set schedule, but it is not as structured as it is in NY.

Regional Variations in Private Equity Recruitment

In markets outside the U.S. and U.K., the interview questions and case studies or modeling tests tend to be similar.

However, the process, timing, and candidates all differ. The industry size and deal focus may also be different.

To give you a specific example, take the private equity market in Brazil.

The main differences vs. the markets in the U.S. and U.K. include:

• The industry is far smaller – total PE deal value is around 5% of the total deal value in North America. As a result, there are fewer firms and fewer positions.

• Growth equity deals are more common than traditional leveraged buyouts; EBITDA growth, rather than financial leverage, drives returns.

• PE firms still hire a lot of former bankers, but you can also join as an undergraduate, do a part-time internship, and convert that into a full-time offer. This move is less common in developed markets.

• The process is far less structured, and almost every firm uses off-cycle recruiting. Headhunters have significantly less power, and you can network your way into interviews more easily. The entire process might take from 3 weeks up to 3-6 months.

• Technical questions and case studies are similar, but you’re more likely to get growth equity cases that involve 3-statement models with minimal leverage rather than traditional LBO models…as you see in this Atlassian growth equity case study.

I’m highlighting Brazil because many of these differences also apply to other emerging markets, such as China, Russia, and India.

In fact, they may even apply to other developed markets that are smaller than the U.S. or Europe.

Even though the process is less structured, it does not necessarily mean that you’ll have an easier time as a non-traditional candidate: there are also fewer firms and fewer positions.

What to Expect in the On-Cycle Process

We published a detailed article about on-cycle private equity recruitment, so I’ll link to that rather than repeating everything here.

To summarize:

• you start working in August as a first-year IB Analyst.
• Within months of that, headhunters, such as CPI, Dynamics Search Partners, SG Partners, Henkel, Amity, and Oxbridge, begin contacting you.
• Then, you’ll schedule your first meetings with headhunters, and you’ll need a very specific idea of the PE firms you’ll pursue (industry, geography, deal type, and size).
• You will have almost no real deal experience by this point, so you’ll have to spin pitches and early-stage assignments into sounding impressive.

After that, you’ll get invited to networking events held by PE firms.

The mega-funds kick off recruiting on Friday night one week, interview each candidate 4-5 times over the weekend, give each one a 2-hour modeling test, and notify the winners by Sunday/Monday.

After that process ends, middle-market funds start and finish recruiting; they still tend to conduct 4-5 interviews and one speed-based modeling test, but they take place over a longer period, such as a week or several weeks instead of 48 hours.

The frustrating part about on-cycle recruiting is that headhunters have a ridiculous amount of power, and they use tunnel vision to filter and recommend candidates.

• If you worked in FIG, good luck winning interviews at tech-focused growth equity firms – even if you mostly worked with fin-tech companies.
• If you worked in Oil & Gas in Houston, good luck winning generalist roles in NY.
• Also, if you’re not at one of the top banks in a solid industry group – rather than ECM or DCM –  and you don’t have an elite university and good GPA, it will be tough to win interviews.

You can practice discussing your deals and building LBO models, and it certainly helps.

But your fate is determined based on events that took place years ago, like that Chemistry final you bombed in your first year of university.

What to Expect in the Off-Cycle Process

The off-cycle recruiting process is the opposite of the on-cycle one:

• Headhunters have little power here; if you’re a non-traditional candidate, headhunters will barely pay attention to you.

• Rather than picking firms based on specific criteria, you should spread as wide a net as possible because the companies that show the most interest may be completely random.

• Rather than starting and finishing in 48 hours or 2-3 weeks, off-cycle processes can last for many months as you meet everyone at the firm multiple times.

These processes are all about your own networking efforts, including LinkedIn/email and any referrals you can get from co-workers, former co-workers, and alumni.

In the on-cycle process, if you have TMT experience, you pretty much have to target TMT-focused PE firms in your area with an AUM between $XX and $YY.

But in the off-cycle process, this would be a mistake: It’s far too specific a goal, and it will artificially limit your options.

Instead, find every boutique and middle-market fund you can, and reach out to Senior Associates and Partners at these firms to present yourself.

Competitive tension is incredibly important because the first question anyone will ask you is: “Who else are you speaking with?”

If you can’t name several other, similar funds, the person will immediately lose interest in you.

Even if you’ve just exchanged emails or LinkedIn messages with someone, spin it into sounding more important: “I’m currently speaking with Firms X and Y, and I have an interview with Firm Z tomorrow.”

You can call informational interviews “interviews” because they do turn into real interviews.

There isn’t necessarily an ideal time to start this process, but you may want to wait until the on-cycle process is done; smaller firms may not even pay attention to recruiting until then.

Private Equity Interview Questions and Answers

Private equity interview questions fall into five main categories:

• Category #1: Fit/Background – Why private equity? What do you know about our firm? What are your long-term goals, and how do we fit in? What are your strengths and weaknesses?

• Category #2: Market/Industry – Which industries do you find interesting? Which companies would you invest in? Which markets do mainstream investors view incorrectly? What makes a market appealing or not appealing?

• Category #3: Technical Questions – These are similar to investment banking interview questions, but sometimes there’s more ‘critical thinking’ involved. For example, they might ask you why two companies with similar growth profiles and margins might trade at very different multiples and what it means for their investment profiles.

You’ll also get questions on tests of mental horsepower, such as “quick IRR math” for leveraged buyouts [Tutorial Video].

Questions will not be exclusively limited to LBOs. Accounting, valuation, DCF models, and even merger models could still come up.

• Category #4: Deals/Clients – You’ll have to walk through at least 1-2 deal/client experiences in-depth, explain what you did, and point to the value you added. Did you find a major mistake in due diligence that saved your client money? Did you find a way to position your client that resulted in new buyers or more qualified interest?

You should also prepare critical views of all your deals: If you were a PE firm, would you have acquired your client? Why or why not? Interviewers often turn your deals around and ask questions like that.

• Category #5: Case Studies and Modeling Tests – Modeling tests can range from 30 minutes (“paper LBOs”) up to 1-3 hours, or even several days to a week.

Types of Modeling Tests

The main categories of modeling tests are as follows:

Very Quick Tests – They might give you 30 minutes and ask you to build a simple LBO model in Excel. Or, they could go the “paper LBO” route (see the link above) and ask you to approximate the IRR using pencil and paper.

Intermediate Tests – These could last from 1 hour up to ~3 hours; you’ll build a real LBO model in Excel, but you may not necessarily build a full 3-statement model. You could easily get away with a cash flow-only model, especially for a 1-hour test. You could also make simplifying assumptions such as using a cash-free debt-free basis.

• Example: Check out this LBO Model Case Study on YouTube.

Take-Home Tests – These are the most difficult ones because you need a real investment thesis, risk factors, and decent industry knowledge.

• Example: This Dell LBO case study is a good example, but the model itself is far more complex than what you normally build. Focus on the short presentation at the end.

You might have a few days up to a week to complete a test in this last category.

Even though you have 10x more time, you should not build a 10x more complex model; spend that extra time learning the industry in-depth and coming up with a solid thesis.

How to Get Into Private Equity: Winning Offers

Most candidates focus far too much on the modeling tests and technical questions and not enough on the other question categories above.

That is a big mistake because private equity interviewers, like investment banking interviewers, ultimately make decisions based on cultural fit.

Yes, you need to know how to build a model, write an investment thesis, and answer technical questions, but those are more like boxes they have to check than anything else.

That is especially the case in off-cycle processes.

The formula for success looks like this:

1. You Can Answer Technical Questions and Build Models Relatively Well – Good! Extra bells and whistles mean less than getting the fundamentals right.
2. You Have Good Reasons for Wanting to Be in the Industry – For example, you have a long track record of investing, you analyze industries for fun, and you have strong views on companies and deals. You’re not just doing it for “improved hours and pay.”
3. You Have Added Value to Deals and are Capable of Running Deals – No one will hire you if they have doubts about your ability to work independently.
4. You Pass the Airport Test – You will be in airports a fair amount, so the Partners and other team members must want to spend time with you.

So You Win a Private Equity Offer: What Next?

If you reach the end of the process and win an offer, congrats!

You should accept it, especially if you won it through an off-cycle process, because your chances of getting into PE are just barely above being struck by lightning.

You could attempt to shop it around and win other offers, and sometimes that will work, especially in the on-cycle process.

But unless you have a really, really good reason for doing that, it’s best to accept your results.

No Offers: What Now?

If you go through the entire process and you don’t win offers, you need to figure out what went wrong.

• Did you not get enough interviews?
• Could you not tell your story effectively?
• Did you fail the technical parts and case studies?
• Did you not have relevant enough experience?

Once you’ve pinpointed the problem, getting brutally honest feedback if necessary, fix it.

You might fix these problems with a different approach to networking, business school, more practice, or a “steppingstone” role, such as Big 4 valuation/M&A, first.

Final Thoughts on Breaking Into Private Equity

Truthfully, the PE recruiting process does not require much intellectual horsepower.

It’s not that difficult to build an Excel model quickly, plan out your story, or prepare deal discussions.

You’re not building rocket ships; you’re doing arithmetic.

The biggest challenge is that many people go into recruiting without a clear idea of what firms are looking for, what your background must look like, and the proper strategy to use.

Get those right, and you might just avoid being tricked on the Internet.

—

If you enjoyed this article, you may be interested in:

• How To Get Into Investment Banking
• The Private Equity Associate: Pathway to Glory, or Glorified Monkey?
• How to Start a Private Equity Firm – and Why You Probably Shouldn’t
• The Private Equity Fund of Funds: Compelling Career, or a Dinosaur Awaiting the Meteor?
• The Complete Guide to Technology Private Equity
• Private equity internship
• Off-Cycle Private Equity Recruiting: How to Win Middle-Market Private Equity Offers
• Family Office Private Equity: The Best Pathway into Finance for Non-Traditional Candidates?
• How to Get into Private Equity from a Middle-Market or Boutique Bank
• From Consulting to Private Equity: How to Make the Leap

The post How to Get Into Private Equity: Step-by-Step Guide appeared first on Mergers & Inquisitions.

A few years ago, I pointed out that there was very little information about real estate private equity online.

But one area has even less information:

Real estate debt funds.

Part of that is because interview guides and articles focus on equity-related buy-side roles.

But it’s also because real estate is specialized, and few people know it in-depth.

Luckily, our readers know a lot about these specialized areas.

And one reader I spoke with recently has a lot to say about this field after he transitioned into it from real estate investment banking:

Background and Breaking In

Q: Can you summarize your story and how you got into real estate IB initially?

A: Sure. I went to a top school in the U.K., but had family issues in my second year and had to take time away from school, earning relatively low grades as a result.

I took a year off and applied for different jobs, including one at a credit rating agency, which I used as a steppingstone into banking.

I was rejected outright at many banks because of my grades, so I had to use aggressive cold calling and cold emailing tactics to break in (your templates helped!).

I finally reached an MD at an elite boutique, made it through interviews, and spun my academic experience positively enough to win an offer.

I did an internship there, won a return offer, and joined the real estate group for my full-time role.

Q: Great. And what was the real estate IB role like in London?

A: We worked on a wide variety of deals, from REITs to individual hotels and offices to portfolio transactions.

Almost every real estate company on the FTSE is structured as a REIT for tax-savings purposes, so the coverage universe was wide.

The best part of the job was that the real estate team did everything, even on deals like IPOs and debt restructurings that are normally handled by the ECM or Restructuring teams.

Since real estate is specialized, it wasn’t possible to “hand off” these deals to the other groups.

There were many cross-border deals, and we looked at properties in Scandinavia, Eastern Europe, Ireland, France, Germany, Portugal, Italy, and so on.

The worst part of the job was that we never worked on the biggest deals because we could not provide financing.

So, if you want to work on the mega-deals in any industry, you’re still better off at a bulge bracket.

Buy-Side Real Estate Recruiting 101

Q: Thanks for that summary.

So, you joined the bank, worked on real estate deals, and then moved into a buy-side role relatively early on.

What was the process like?

A: Compared with the PE/HF recruiting process in North America, it is very unstructured here.

Lots of smaller and mid-sized funds will hire anyone at any time; if you interview and win an offer in March, your job might start in April.

Larger funds stick to more of a set schedule and tend to hire bankers after their first years finish up in September.

But the timing is slower than in the U.S.; headhunters began contacting me in January/February, about six months after I started, and I began responding in March.

There is a massive dearth of buy-side real estate talent in London, in both equity and debt, because it’s specialized and funds always prefer people with previous RE experience.

As a result, it’s easier to win buy-side real estate roles than it is to win the same roles at generalist funds.

The first round of almost every interview, for both equity and debt roles, was a modeling test.

The standard LBO model was the most common test for equity roles, while credit funds gave tests where you had to build a cash flow schedule and track credit stats and ratios based on a tenancy schedule, expected costs, and revenue.

Your real estate financial modeling course is good preparation for these types of tests.

Q: Which one was more difficult, and why did they start with the modeling tests?

A: The debt tests were more difficult because they were ad hoc.

They could always change assumptions like the free months of rent, concessions, and renewal probability, and you’d have to write new formulas based on the logic.

By contrast, most LBO models were “paint by numbers”: Once you’ve practiced enough, you can complete them with your eyes closed.

Most funds started with these tests because modeling is a pre-requisite for any buy-side role.

Q: That makes a lot of sense.

Beyond the case studies, were any particular questions difficult?

A: Not really.

Following the modeling tests, most funds did a few rounds of interviews where they asked the standard “fit” questions: Why real estate, why do you want to move to the buy-side now, and so on.

The “Why Real Estate?” question should be easy if you’re already in a real estate group: You gave up a generalist group and broader opportunities because you wanted to focus on this industry.

I sometimes received more open-ended questions and case studies at smaller funds, and some of those required real estate market analysis as well.

They might have asked me to discuss the investment merits of a specific REIT or property, and it turned into more of a conversation and less of a formal presentation.

Q: You interviewed for both debt and equity real estate funds.

Why did you settle on a debt fund?

A: First, the CRE lending space in the U.K. has changed dramatically over the past 5-10 years, and alternative credit providers now own about 15-20% of the market.

In the distant past, commercial banks provided most of the lending, and alternative providers had only about 2% of the market.

Insurers, such as Aviva, are also playing a bigger role in this market because senior CRE lending is now seen as a legitimate alternative to fixed income investing.

I also knew that I would get more deal exposure and close more deals if I went to a debt fund.

I do like the higher IRRs in the equity space, but most of my offers there were from smaller funds that worked on smaller deals.

Given those factors, it made sense to accept an offer at a mid-sized credit fund that does both senior and mezzanine deals.

On the Job at a Real Estate Debt Fund

Q: Thanks for explaining that. What has the job been like so far?

A: The most obvious difference vs. investment banking is that the work/life balance is far better.

I no longer create pitch books, and I only write occasional credit memos, so there’s far less grunt work.

I also see far more deals than I did in banking, and the work is more interesting because we have to dig into the numbers and think critically about each assumption.

Q: In traditional private equity, people often complain that they rarely close deals because they pass on 99% of companies.

What is the ratio like at your fund?

A: The “pass ratio” is far lower for senior debt because there’s less risk, and the Principals often do a quick check before asking us to evaluate deals.

We take around 65% of senior debt deals to the credit committee and then proceed with ~50% of those. So, we complete roughly 1/3 of all senior deals and pass on 2/3 of them.

The percentage is lower for mezzanine deals because there’s significantly more risk and we have to evaluate assets from the equity perspective as well.

We take around 50% of mezzanine deals to the credit committee and proceed with ~25% of those. So, we pass on 85-90% of all mezzanine deals and complete 10-15% of them.

Q: And how do you evaluate these deals?

A: Debt analysis is based on the downside case, so we start by ignoring the sponsor’s business plan and coming up with our own assumptions.

Their numbers can be so wildly unrealistic – valuation differences of 50% or more – that it’s important for us to come up with more reasonable figures first.

Then, we’ll look at what happens when vacancy rates increase, rents fall, and expenses rise, and evaluate the likelihood of an Armageddon-like scenario.

Mezzanine analysis is more like traditional equity analysis, and so we have to buy into the “story” for the numbers to work.

We rarely do mezzanine deals with equity participation, but that gives us an advantage because we can also demand a higher coupon rate than a fund that wants the participation.

We tend to underwrite deals to target specific IRRs, but we can also internally leverage loans to boost those returns.

For example, we might internally leverage a 70% Loan-to-Value (LTV) loan at 40% and turn a potential IRR of 10% into a 15-16% IRR.

When you’re not taking equity risk, that’s a great result.

Q: Thanks for explaining all that.

What are the typical exit opportunities from these funds?

A: The most common paths are:

• Go back to an investment bank, but at a higher level – For example, you might spend five years at a credit fund and then join a bank at the Director level.
• Join a real estate private equity fund – You learn to be very granular in your analysis when you underwrite debt deals, and those skills are useful on the equity side as well. Sometimes you also see level skipping here.

Many credit funds are also being acquired, so that could be another “exit.”

I plan to stay in this industry, but I would like to work in the U.S. for a few years to learn a different market.

Q: Great. Any final thoughts?

A: If you want to close deals, work at a credit fund, not a traditional PE fund!

I closed only a few deals in my entire time at a bank, but I’m on track for ~1 per month here so far (though I’ll admit it would be unrealistic for this to continue forever!).

The level of responsibility is also much higher since I’m now running deals, and my work tends to get checked later in the process – which means it needs to be correct, or the whole process will be delayed.

If you’re looking for those points, you should at least consider credit funds.

Q: Thanks for your time.

A: My pleasure.

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If you start a business selling crystal meth from your RV, could it resemble a Fortune 500 company?

Last time around, I used Walter and Jesse’s conversation in Breaking Bad about Meth Businesses, Money Businesses, and Empire Businesses to explain private company valuation.

Most people incorrectly assume that all “private companies” are valued in the same way.

But they’re not: Does Ikea resemble a 5-person barber shop?

You can divide private companies into true small businesses (“Money Businesses”) that are dependent on a few people, startups that want to get big quickly (“Meth Businesses”), and huge companies that just happen to be private (“Empire Businesses”).

Valuation differs a lot for small businesses, but far less for huge private companies.

But that’s not quite right, either.

It’s a very traditional way of looking at this topic: Using public company valuation as a starting point and explaining the differences.

But the lines between public and private companies have been blurring.

Rather than thinking about the category a company is in, you should think about where it is in the “gradient” between public and private.

And rather than assuming there are “differences” in private company valuation, you should use these differences to question the basic tenets of traditional valuation.

Why the Public/Private Lines Have Blurred

Regulatory changes, market practices, and new investors have blurred the lines:

Change #1: Startups Are Staying Private for Much Longer

Google was founded in 1998 and went public in 2004; Cisco was founded in 1984 and went public in 1990; Amazon was founded in 1994 and went public in 1997.

Companies did this because they had to: There weren’t many late-stage investors willing to sink hundreds of millions into cash-flow-negative startups to fund growth.

Past a certain point, startups had to tap the public markets for capital.

But Facebook changed all that by accepting huge late-stage investments from DST and Microsoft, and companies like Airbnb, Uber, and Xiaomi have taken that trend even further with multi-billion-dollar rounds of debt and equity.

It’s misleading to think of these large, late-stage startups as “private companies”; they’re more like public companies with small floats and limited information.

Change #2: Secondary Markets Allow You to Buy and Sell Private Company Shares

Decades ago, it was impossible to buy shares in a private company unless you worked at the company.

But SecondMarket (now NASDAQ Private Market) changed that when it started listing shares of private companies and letting market participants buy and sell them.

It’s now feasible to acquire shares of tech startups and other private companies even if you haven’t worked at any of these firms.

Some startups even encourage employees to sell their shares – companies like Atlassian and Airbnb did this in their late-stage funding rounds.

Change #3: New Regulations Let Normal People Invest in Private Companies

In the U.S., “Reg A+” is a part of the JOBS Act that lets companies raise up to $50 million from both accredited and non-accredited investors.

After that, the FAST Act formalized rules on trading the shares of private companies.

And then Regulation Crowdfunding went into effect, which allows capital raises of up to $1 million from the general public with minimal disclosure requirements.

To go beyond that, though, companies need audited financial statements and public SEC reports under Reg A+.

Therefore, to raise money from this broader group of investors, private companies already need to resemble public companies.

This dynamic has led to another change:

Change #4: Large Asset Managers Publicly Report the Value of Their Holdings

As asset managers such as Fidelity and T. Rowe Price have gotten into the startup investing game, they’ve also been reporting on the values of their portfolio companies quite publicly.

This move surprised many in Silicon Valley, who had assumed that these newcomers would just hold their investments at cost.

But this trend makes perfect sense: If you want to raise money like a public company and attract a broader investor base like a public company, you must disclose information like a public company and handle valuation ups and downs like a public company.

If you can Google a company and find its revenue for the past two years and current valuation, it’s not a real private company.

What Hasn’t Changed: Private Companies with No Inclination to Go Public

Most of these changes refer to tech and biotech startups.

There have been fewer changes in the lower end and the upper end of the private company universe.

It’s not feasible for true small businesses to get audited financial statements or to set up strict controls and corporate governance, nor do they have any reason to.

Why would a family-run hotel chain started in 705 (yes, over 1300 years ago) want to raise capital on a crowdfunding site?

At the upper end, little has changed because huge businesses have no reason to make their shares available, disclose more information, or raise outside capital.

So, What Makes a Company “Private”?

Fred Wilson put it very well in his post on The Blurring of Public and Private Markets:

“The more a company discloses, the more liquid their securities become.”

The truth is that many private startups are, effectively, public companies.

Rather than dividing companies into “public” and “private,” you should think of it as a gradient: Some companies are more public, and others are more private.

Since the classifications have blurred, the valuation differences have also blurred.

Financial Statement Analysis and Accounting

Many private companies do not report items in a “standard” way on their financial statements.

For example, many business owners take a small salary but also pay themselves a dividend that’s taxed at a lower rate.

An acquirer or investor would re-classify that “dividend” into operating expenses for the company.

These are common problems for private companies, but you shouldn’t assume that all public companies have completely fine financial statements.

For example, we recommend converting Cash Flow Statements created with the Direct Method to ones based on the Indirect Method instead, as it makes modeling and valuation far easier.

You should question many of the assumptions and disclosures of public companies as well:

• Should Stock-Based Compensation be added back to calculate EBITDA? Answer: No! It’s not even a real non-cash expense, and it’s certainly not a non-recurring expense.

• Should a company be allowed to use a ridiculous metric like “Adjusted Consolidated Segment Operating Income,” as Groupon famously tried to do? Answer: No!

• Is that “Restructuring” expense that has appeared for 8 of the past 10 quarters a true “non-recurring expense”? Answer: No!

Private Company / “Illiquidity” Discounts

Since many companies achieve higher valuations in the private markets than they do in the public markets, it’s misleading to assume that all private companies are worth less than their public peers.

If a private company’s shares trade like those of a public company and you can easily find its financial stats, you shouldn’t be applying much of a discount.

On the other side, you could arguably apply an illiquidity discount to certain public companies.

For example, if the company is public but its float consists of only 10% of its shares, is it “liquid”?

Or if there’s such limited trading volume that it’s impossible to exit a large position quickly, is the company “liquid”?

DCF Analysis – Terminal Value

And now to the punch line: The concept of Terminal Value in the DCF analysis is flawed.

The fact that you have to discount it in a private company DCF demonstrates its flaws.

The problem is very simple: No company, public or private, lasts forever.

Sure, a large, well-run public company will probably last longer than a family-run wine shop, but the lifespan of all public companies has been falling:

Historically, the average lifespan of multinational corporations was only 40-50 years.

That may seem like a small difference initially:

But if a company dies after 40-50 years, its cash flow will not keep growing by 3% per year and then suddenly drop to 0 after Year 40 or Year 50.

A more realistic assumption is that FCF growth will slow down after the first 10 years, and then FCF will start declining midway through the period as the company shrinks:

If that happens, the discrepancy is more like 15-20%, which is significant.

And if the company goes out of business more quickly, the discrepancy will be even greater.

I’m not the first one to notice this problem; a few professors from Portugal also covered it in an academic paper:

The following approaches to a DCF might be better:

• The “Project Finance” / “Oil & Gas“Approach: Project a company’s cash flows further into the future (say, 20-30 years), and assume that the company shuts down or fails after a certain point.

• Use an analysis like the Residual Income Model where “value” is created only if ROIC
  exceeds WACC (or if ROE exceeds Cost of Equity). In these models, most of a firm’s value is based on its current Balance Sheet. For more on ROIC, see our tutorial on ROIC vs ROE and ROE vs ROA.

• Discount the Terminal Value (before you discount it to its Present Value) to reflect how the business will eventually die, or use the company’s future Liquidation Value instead.

Bankers will not understand these points, so don’t bring them up in interviews.

However, if you’re in an interview you don’t care about and you want to see the other person squirm, you could try arguing your case.

Point out that:

• ~10% of public companies fail each year, which is up from 2.5% in 1965.
• The 5-year mortality risk is between 25% and 40%, depending on the sector.
• ~75% of S&P 500 firms will be replaced by new firms in the next 10 years.

And see what they think about Terminal Value in light of these stats.

The Implications: Can You Make Money from Mispriced Companies?

If Terminal Value overstates most companies’ implied values, you might think you could make money by shorting companies, particularly ones that are likely to be disrupted.

But that may be easier said than done because:

• There’s often no clear catalyst.

• You’d need a long holding period for these valuation discrepancies to unravel.

• Valuation is based on future expectations. If everyone’s expectations are wrong, and everyone continues to be wrong… nothing changes.

Physics to Finance

One of the great unsolved problems in physics is how to unify quantum mechanics and general relativity.

The fact that the theories and math are different feels wrong; it seems like there should be one grand theory that ties everything together.

I think of public and private company valuation in the same way.

Fortunately, it’s easy to reconcile these concepts in finance: Public company valuation should be more like private company valuation – so eliminate some of the differences.

You shouldn’t take a public company’s financial statements at face value.

You shouldn’t assume that all public companies are equally “liquid.”

And you shouldn’t assume that a public company can operate indefinitely or grow at the same rate until the end of time.

Change those assumptions, and that crystal-meth-cooking RV might start to resemble a Fortune 500 company – after you do enough meth, of course.

• Private Company Valuation, Part 1 – Key Differences and the “Classical” View of Private Companies
• Private Company Valuation, Part 2 – How the Public and Private Lines Are Blurring

The post Private Company Valuation, Part 2: Could You Be in the Meth Business *and* the Empire Business? appeared first on Mergers & Inquisitions.