One of the best parts of working at a hedge fund, besides the enormous piles of gold lining your mansion, is the fact that no one else understands what you do.
In the second part of this interview on distressed hedge funds, you’re going to learn all about what you do on the job, how you make investment decisions, and more.
Here’s what you’ll learn inside:
- What “distressed investing” means and what types of securities you’d focus on.
- How financial modeling differs at hedge funds.
- What an average day in your life will be like at a hedge fund.
- How much money you’ll make at the entry-level, and as you move up the ladder.
Worried that hedge funds will lose some of their appeal now that all this information is out there in the public domain?
Don’t worry – at least you’ll still have your gold-lined mansion(s).
Let’s get started:
Distressed Investing from A to Z
Q: Let’s move into what you do on the job: what exactly is distressed investing, and how does the process work from beginning to end?
A: Sure. So, first off, the name “distressed investing” is actually a misnomer because we do a lot more than that.
In addition to real distressed companies, we look at anything that might be misunderstood by the market, over-leveraged but “good” companies, or ones that are otherwise at a disadvantage.
Investing in actual distressed companies, by contrast, means that you find firms that are having some type of financial trouble, are unable to fund their debt obligations, or are otherwise on the brink of bankruptcy, and then investing in their capital structure.
At my firm, we invest across everything; anything or any part of the capital structure that’s undervalued is fair game.
So if a large-cap firm is set to issue bonds at a 9% yield, for example, we might look at the firm’s capital structure and operations, and then figure out whether we should invest in their common equity or those bonds.
We focus on finding securities that are trading at huge discounts because most other people don’t understand them or don’t have the time to understand the complexity of the problem(s).
A lot of my work involves determining the effective yield of different securities – if the yield is less than 10%, we don’t pay much attention to it. We try to find securities that yield at least 10%, if not more than that.
And then we get into calculating the associated risk with the yield – finding the yield is just the first filtering point.
Q: So the yields on the bond side are pretty simple to figure out – just pull the information form Bloomberg – but what about for equities? How do you figure out the potential appreciation of a stock?
A: That comes down to digging into the company’s operating model and determining the key revenue and cost drivers for the year.
We’ll try to find a company that is undergoing some financial trouble – such as being over-leveraged or that is having macro problems but which is still a fundamentally good company – and then see which part of the capital structure we should invest in.
Let’s say, for example, that the company is valued at 7x EBITDA and the senior secured debt trades at 5x EBITDA – in that case we can essentially get our money back if things fail, so we’ll decide whether or not the equity is worth the risk.
We often use strategies such as longing one part of the capital structure and shorting another one.
We’ll talk to the industry consultants first and then the sell-side equity research analysts and ask what they think of the company’s prospects and the industry as a whole, the competition, and, if the company is in a distressed situation, whether or not it will survive.
The entire modeling and valuation process is very similar to what you do in banking.
But the difference is that on the buy-side, we actually care about the numbers – in banking, you might just enter a blind assumption like 10% revenue growth and 20% EBITDA margins, but here we would dig into all those numbers.
So to assume something like 10% revenue growth, we would need to understand where it’s coming from – Increased unit sales? Price increases? Wider distribution? And we would do channel checks and speak with a lot of people to verify those assumptions.
Then, based on the model and valuation we develop, we would see whether or not the company’s stock price might reasonably increase in a certain timeframe.
So if it’s trading at a 10x EBITDA multiple right now and we think revenue growth will exceed what the market expects, could its multiple increase? Or could anything else drive its stock price upward?
Q: Right, so it’s sort of like the difference between undergraduate and grad school: there’s less BS and more focus on work that actually matters.
What about on the distressed side specifically? How is the work different when you’re working with troubled companies?
A: There, we put a lot of thought into how the debt is valued and whether or not we can invest at a cheap price.
So if we can get in at a discount price, we might be able to win the company’s assets if and when the company files for bankruptcy.
It depends a bit on what the ultimate outcome of the bankruptcy is – Chapter 7? Chapter 11? A distressed sale? – but those are issues we would think about.
Normally there’s a lot of overlap with the legal side in distressed M&A, but at least at our fund, a team of lawyers helps out with anything legal that comes up and we consult with them when asking about what might happen, how it could impact the returns, and so on.
Q: What about an average day in your life? What does a hedge fund analyst / associate actually do?
A: I generally get in around 6 AM because I’m on the west coast of the US, but the markets are based on Eastern Time; if you’re in NY or somewhere else with no time zone difference, you would not have to arrive that early.
Some people actually have to arrive even earlier than me depending on their fund’s strategy – since we focus more on value investing, I need to be here by the time the market opens but not hours in advance or anything.
When I’m at the office I spend most of my time researching new investments, updating our models for companies we’re looking at, reading news sources, and speaking with sell-side analysts.
I might also work with the more senior people on my team to go through models and determine the valuation of different stocks.
Some meetings can last 2 – 3 hours, so what I described above often takes up the majority of the day.
That may not sound terribly exciting, but then we also don’t have to deal with constant client emergencies, crazy VPs punching their fists through car windows, and all the fun you see in banking.
Generally the junior analysts here focus on modeling and research work, and the associates are tasked with meeting people, coming up with investment ideas, and vetting investment ideas that other people have come up with.
No one does much sourcing (i.e. cold calling) here – overall, it’s far more common in PE/VC and especially in growth PE.
We also get tons of inbound emails (100+ per day) from bankers pitching secondary equity and debt offerings (we rarely buy primary offerings), so there isn’t much of a need to cold call companies.
I usually leave around 7 to 9 PM – roughly the same as sales & trading hours. On weekdays I don’t have much free time since I have to wake up so early, but weekends are usually free.
The Ladder, the Pay, and the Exit Opps
Q: You mentioned just now how analysts and associates focus on different tasks at your fund.
What about the rest of the hierarchy? How is it set up, and how do you advance?
A: At my office, it’s relatively “flat” in that if you have a great idea, you can go talk to the Partners directly.
It’s not like banking where you have to run everything you do up the chain from associate to VP to MD before anyone can make a decision.
As for the structure, it’s Analyst, Associate, and the Partners of the firm at the top.
There isn’t a strict set of years required to advance – it’s more about how much you produce (come up with great investment ideas, and then keep coming up with them) rather than how long you’ve been there.
Generally, though, “Analysts” are straight out of a 2-year investment banking role and “Associates” have more like 5+ years of experience, usually in banking and then in something else on the buy-side after that.
Usually you’re an Analyst for about 2 years, and after that, you either get promoted, you move somewhere else, or you go back to business school.
It is very, very difficult to make the leap to Partner here – much harder than it is in investment banking, where you simply have to land a certain number of clients/deals as a VP to advance.
You’ll never make it here unless you come up with great investment ideas and achieve great returns.
As a result, there’s a massive gap between Partners and everyone else. It’s much more lopsided than what you see on the sell-side, where MDs are compensated well, but not 50x better than everyone else.
Q: And speaking of compensation, how exactly does it work? We all hear stories of people earning ridiculous bonuses at hedge funds, but is that always what happens?
Is it based on a percentage of your P&L, as in prop trading, or is it more standardized at the junior levels?
A: I hate to always respond with, “It depends on the fund” – but that’s the truth.
Usually the Partner-level people are the ones who really benefit from the 2% management fee and the carry, because they take the bulk of that for themselves.
So let’s say you’re at a $5 billion fund and you therefore have $100 million in management fees to go around each year.
The Partners might take 60 – 70% or more of that and therefore leave only 30-40% for the dozens of other professionals there. That still adds up to a lot of money, but you can see how the senior people make the truly out-sized paydays – just from the management fees alone.
If they have a good year and get even a 10% return, that’s another $100 million (10% * $5B * 20%) they get for themselves. So Partners can easily earn in the tens of millions per year.
I can’t speak to Associate pay, but as an Analyst at a mid-sized fund you might make around $100K USD base salary with a $100 – $120K USD bonus – and if your fund does well, you might see more than that.
I would assume that Associates, just as in banking, make significantly more than that and that you generally make more at bigger funds since there are higher management fees to go around (supporting data).
Q: Right, so basically you’re still well-compensated at the junior levels, but it’s not necessarily a dramatic increase over what you would earn as a 2nd or 3rd year analyst in IB, at least when you’re an entry-level analyst at a mid-sized fund.
What about the exit opportunities? Is it true that it’s much more difficult to move around in the hedge fund world since your skills are so specialized?
A: Most often, people go to business school or get promoted internally.
If you’ve broken into the hedge fund industry and you leave altogether, it means you either weren’t good at your job or you’ve decided that finance isn’t for you.
You’re correct that there’s more movement within investment banking and private equity – there, the skill sets are very transferrable between different firms and groups, so moving around isn’t as much of an issue.
Many hedge funds, by contrast, are looking for people with very specific experience – European telecom M&A arbitrage, for example – and may ignore you if you don’t match their profile 100%.
So it’s uncommon to move from, say, merger arbitrage to a value fund, or to move from a global macro fund to a value fund.
And as your previous interviewees have confirmed, even moving to and from prop trading is difficult because most prop trading firms focus on market making rather than directional trading.
But moving from, say, a value fund to another value fund is not that uncommon, nor is moving from a macro fund to another macro fund.
Q: Awesome. So you either stay in and get promoted, you move to another closely-related fund, or you go back to business school.
Which of those options will you pursue? Any big exit opportunities you have planned?
A: Not sure yet – will have to see what my bonus looks like this year first!
Q: Not a bad way to make a decision. Thanks for the chat!
A: Yup, enjoyed speaking!
M&A Boutique to Distressed Hedge Fund Series: