After doing a master’s degree in Finance, there are many career opportunities one can access. However, the choice for the most competitive candidates, who attend the best schools, usually boil down to either Investment Banking or Private Equity. Today we will take a look at these options in order to understand what a career in the highest chambers of finance might look like.
Investment Banking:
Investment Banking is an expression used to refer to the activity of connecting SSU’s, operators with more money than they need, with DSU’s, the ones with less money than what is necessary in order for them to undertake specific investment projects.
Investment banks (JP Morgan Chase, Goldman Sachs, Morgan Stanley, HSBC, BNP Paribas, ecc.) are the entities that play a key role in ensuring this “Connection” and helping private investors to modify the composition of their own investment portfolios, operating as market intermediaries that do not correspond to the traditional commercial banks. In fact, the latter simply take deposits and then decide how to invest the funds previously collected. With respect to the US context, while the Glass-Steagall Act of 1933 forbad the possibility of conducting commercial and investment banking activities simultaneously, this “Split” was canceled by the Gramm-Leach-Bliley Act of 1999.
Initially, investment banks were only responsible for organizing the issue of securities on financial markets and searching investors interested in underwriting those financial instruments. Then, these institutions started getting involved in the creation of collective investment funds as well as private management of the biggest clients’ funds (Private Banking) and quoting two-sided markets in a specific security (Market-Making). Finally, they became very interested in offering Corporate Finance services and so giving support in mergers and acquisitions (M&A) operations, equity and debt advisory and buying participations in non financial businesses became relevant features of their activity, alongwith Risk Management.
Brokering, Private Banking, Trading (investment banks usually have a trading desk that deals with currencies, fixed-income assets, derivatives, exotic options, ecc.) and long term financing of infrastructure projects are not to be confused with the true core business of Investment Banking represented by all the interventions aimed at assisting firms by, for example, giving help during the placement of securities, obtaining funds through capital markets and advising about valuations, M&A and debt restructuring.
Through their unique expertise and capabilities, investment banks are able to manage and reduce drastically 3 costs: transaction costs (thanks to their economies of scope and scale as well as reduced analysis costs), asymmetry of information and contractual costs (these are related to defining all the various contractual features of the operation to be put in place).
In Italy, this highly specialized segment of finance is not as developed as in the rest of Europe and, especially, the USA, with very few relevant operators from an international point of view (for example Mediobanca and, on a lower level, IMI Intesa Sanpaolo).
Private equity:
Private Equity (PE) is the ownership or interest in an entity that is not listed in any stock market. It is a particular asset class reserved for institutional investors or high net worth individuals. Private Equity funds are created by PE firms thanks to client capital, which are investing in the fund to take profit from the operations and choices of the firm. Typically, investors in this asset class are required to commit their capital for years. This is why access to such investments is limited to institutions and high net worth individuals. Private Equity funds buy companies that are already well-structured with a potential growth margin, and then sell their stakes, usually when the company does an IPO (initial public offering). In fact, when PE firms buy a company, they already have in mind a business plan that could raise the value of the company. These plans are usually going to make both the firm and the management happy, as they are going to make the company worth more, even if they could include dramatic cost cuts or a restructuring, steps that the management might have been reluctant to take. The activity of the firm, though, does not end only in providing capital to the company, but also in bringing more expertise and being active in the everyday decisions and challenges that the company is going to face, to the point that the PE firm might bring its own management team inside of the company. Private Equity investing tends to be more lucrative and popular amid investors during periods when stock markets are rallying and interest rates are low, and less so when those cyclical factors tend to be less favorable. Private Equity funds have a finite term of 10 to 12 years, and the funds do typically start to distribute profits to their investors not from the beginning, but after several years.
How do Private Equity firms generate value?
Private Equity is known in the finance sector as one of the most lucrative activities that there is. These firms have a part of their revenue that is fee-based, that means that the fund makes money from fees that clients pay to have their funds managed. But this is just a small part of the revenue that the firm generates. The biggest part is from a share of the profits from their operations that the fund gets above a preset minimum known as the hurdle rate. In PE, the hurdle rate is the minimum rate of return a fund has to achieve before the general partners (GP’s) or managers start receiving a share of the profits, that is called carried interest. This hurdle rate acts like a performance threshold that ensures limited partners get a certain return on their investment before GP’s receive theirs, and it varies based on the fund strategy and the agreement between LP’s and GP’s. Once the hurdle rate is reached, the GP’s start to get their share of profits, that is often about 20% of the fund’s returns above the hurdle rate. To understand better the amount of money that these firms make, let’s see an example. Suppose that there is a PE fund with these details:
– Fund size: $100 million
– Hurdle rate: 8% a year
– Carried interest: 20% for the GPs.
If the fund’s return is below 8%, all returns are distributed to the LP’s (investors) and the GP’s (the firm) does not receive carried interest. On the other hand, if the fund’s return are above 8%, any returns above 8% are shared between LP’s and GP’s, who receive about 20% in this example.With the hurdle rate, the firm is incentivised to perform better and to go above it in order to achieve a larger share of profits.
What’s the difference between Private Equity and Venture Capital?
In the financial sector, it is common to see PE and Venture Capital grouped together, and even if they are 2 very similar types of investment, they are a bit different. While Venture Capital invests and finances startups, Private Equity firms and funds invest in companies that are already structured and that are more “mature” than startups.
Authors: Filippo Ferrero and Piero Foberti