You do not need to be a math genius or a gifted speaker; you just need to understand the recruiting process and basic arithmetic.

Still, there is more to PE interviews than “2 + 2 = 4,” so let’s take a detailed look at the process:

How to Network and Win Private Equity Interviews

The Private Equity recruiting process differs dramatically depending on your current job and location.

Here are the two extremes:

• Investment Banking Analyst at a Bulge Bracket or Elite Boutique in New York: The process will be highly structured, and interviews will finish at warp speed. In some ways, your bank, group, and academic background matter more than your skill set or deal experience. This one is known as the “on-cycle” process.
• Non-Banker in Another Part of the U.S. or World: The process will be far less structured, it may extend over many months, and your skill set and deal/client experience will matter a lot more. This one is known as the “off-cycle” process.

If you’re in between these categories, the process will also be in between these extremes.

For example, if you’re at a smaller bank in NY, you may complete some on-cycle interviews, but you will almost certainly also go through the off-cycle process at smaller firms.

If you’re in London, there will also be a mix of on-cycle and off-cycle processes, but they tend to start later and move more slowly than the ones in NY.

We have covered PE recruiting previously (overall process and what to expect in the on-cycle process), so I am not going to repeat everything here.

Interviews in both on-cycle and off-cycle processes test similar topics, but the importance of each topic varies.

The timing of interviews and start dates, assuming you win offers, also differs.

The Overall Private Equity Interview Process

Regardless of whether you recruit in on-cycle or off-cycle processes, or a combination of both, almost all PE interviews have the following characteristics in common:

• Multiple Rounds: You’ll almost always go through at least 2-3 rounds of interviews (and sometimes many more!) where you speak with junior to senior professionals at the firm.
• Topics Tested: You’ll have to answer fit/background questions, technical questions, deal/client experience questions, questions about the firm’s strategies and portfolio, market/industry questions, and complete case studies and modeling tests.

The differences are as follows:

• Timing and Time Frame: If you’re at a BB/EB bank in NY, and you interview with mega-funds, the process starts and finishes within several months of your start date at the bank (!), and it moves up earlier each year. Interviews at the largest firms start and finish in 24-48 hours, with upper-middle-market and middle-market firms beginning after that.

By contrast, interviews start later at smaller PE firms, and the entire process may last for several weeks up to several months.

• Importance of Topics Tested: At large funds and in the on-cycle process, you need to complete modeling tests quickly and accurately and spin your pitches and early-stage deals into sounding like real deals; at smaller funds and in off-cycle interviews, the reasoning behind your case studies/modeling tests and your real experience with clients and deals matter more.

Firm-specific knowledge and fitting your investment recommendations to the firm’s strategies are also more important.

• Start Date: You interview far in advance if you complete the on-cycle process, and if you win an offer, you might start 1.5 – 2.0 years later. With the off-cycle process, you start right away or soon after you win the offer.

Private Equity Interview Topics

There is not necessarily a correlation between the stage of interviews and the topics that will come up.

You could easily get technical questions early on, and you’ll receive fit/background and deal experience questions throughout the process.

Case studies and modeling tests tend to come up later in the process because PE firms don’t want to spend time administering them until you’ve proven yourself in previous rounds.

However, there are exceptions even to that rule: For example, many funds in London start the process with modeling tests because there’s no point interviewing if you can’t model.

Here’s what to expect on each major topic:

Fit/Background Questions: “Why Private Equity?”

The usual questions about “Why private equity,” your story, your strengths/weaknesses, and ability to work in a team will come up, and you need answers for them.

We have covered these in previous articles, so I’ve linked to them above rather than repeating the tips here.

Since on-cycle recruiting takes place at warp speed, you’ll have to draw on your internship experience to come up with stories for these questions, and you’ll have to act as if PE was your goal all along.

By contrast, if you’re interviewing for off-cycle roles, you can use more of your current work experience to answer these questions.

While these questions will always come up, they tend to be less important than in IB interviews because:

• In on-cycle processes, it’s tough to differentiate yourself – everyone else also did multiple finance internships and just started their IB roles.
• They care more about your deal experience, whether real or exaggerated, in both types of interviews.

Technical Questions For PE

The topics here are similar to the ones in IB interviews: Accounting, equity value and enterprise value, valuation/DCF, merger models, and LBO models.

If you’re in banking, you should know these topics like the back of your hand.

And if you’re not in banking, you need to learn these topics ASAP because firms will not be forgiving.

There are a few differences compared with banking interviews:

• Technical questions tend to be framed in the context of your deal experience – instead of asking generic questions about WACC, they might ask how you calculated it in one specific deal.
• More critical thinking is required. Instead of asking you to walk through the financial statements when Depreciation changes, they might describe companies with different business models and ask how the financial statements and valuation would differ.
• They focus more on LBO models, quick IRR math, and your ability to judge deals quickly.

Most interviewers use technical questions to weed out candidates, so poor technical knowledge will hurt your chances, but exceptional knowledge won’t necessarily get you an offer.

Talking About Deal/Client Experience

This category is huge, and it presents different challenges depending on your background.

If you’re an Analyst at a large bank in New York, and you’re going through on-cycle recruiting, the key challenge will be spinning your pitches and early-stage deals into sounding like actual deals.

If you’re at a smaller bank, and you’re going through off-cycle recruiting, the key challenge will be demonstrating your ability to lead, manage, and close deals.

And if you’re not in investment banking, the key challenge will be spinning your experience into sounding like IB-style deals.

Regardless of your category, you’ll need to know the numbers for each deal or project you present, and you’ll need a strong “investor’s view” of each one.

That’s quite a bit to memorize, so you should plan to present, at most, 2-3 deals or projects.

You can create an outline for each one with these points:

1. The company’s industry, approximate revenue/EBITDA, and multiples (or, for non-deals, estimated costs and benefits).
2. Whether or not you would invest in the company’s equity/debt or acquire it (or, for non-deals, whether or not you’d pursue the project).
3. The qualitative and quantitative factors that support your view.
4. The key risk factors and how you might mitigate them.

If you just started working, pick 1-2 of your pitches and pretend that they have progressed beyond pitches into early-stage deals.

Use Capital IQ or Internet research to generate potential buyers or investors, and use the company-provided pitch materials to come up with your projections for the potential stumbling blocks in the transaction.

For your investment recommendation, imagine that each deal is a potential LBO, and build a quick, simple model to determine the rough numbers, such as the IRR in the baseline and downside cases.

For the risk factors, reverse each model assumption (such as the company’s revenue growth and margins) and explain why your numbers might be wrong.

If you’re in the second or third categories above – you need to show evidence of managing/closing deals or evidence of working on IB-style deals – you should still follow these steps.

But you need to highlight your unique contributions to each deal, such as a mistake you found, a suggestion you made that helped move the financing forward, or a buyer you thought of that ended up making an offer for the seller.

If you’re coming in with non-IB experience, such as internal consulting, still use the same framework but point out how each project you worked on was like a deal.

You had to win buy-in from different parties, get information from groups at the company, and justify your proposals by pointing to the numbers and qualitative factors and addressing the risk factors.

Firm Knowledge

Understanding the firm’s investment strategies, portfolio, and exits is very important at smaller firms and in off-cycle processes, and less important in on-cycle interviews at mega-funds.

If you have Capital IQ access, use it to look up the firm.

If not, go to the firm’s website and do extensive Google searches to find the information.

Finding this information should not be difficult, but the tricky point is that firms won’t necessarily evaluate your knowledge by directly asking about it.

Instead, if they give you a take-home case study, they might judge your responses based on how well your investment thesis lines up with theirs.

For example, if the firm makes offline retailers more efficient via cost cuts and store divestitures, you should not present an investment thesis based on overseas expansion or roll-ups of smaller stores.

If they ask for an investor’s view of one of your deals, they might judge your answer based on your ability to frame the deal from their point of view.

For example, if the firm completes roll-ups in fragmented industries, you should not look at a standard M&A deal you worked on and say that you’d acquire the company because the IRR is between XX% and YY% in all scenarios.

Instead, you should point out that with several roll-ups, the IRR would be between XX% and YY%, and even in a downside case without these roll-ups, the IRR would still be at least ZZ%, so you’d pursue the deal.

Market/Industry

In theory, private equity firms should care about your ability to find promising markets or industries.

In practice, open-ended questions such as “Which industry would you invest in?” are unlikely to come up in traditional PE interviews.

If they do come up, they’ll be in response to your deal discussions, and the interviewer will ask you to explain the upsides and downsides of your company’s industry.

These questions are more likely in growth equity and venture capital interviews, so you shouldn’t spend too much time on them if your goal is traditional PE.

And even if you are interviewing for growth equity or VC roles, you can save time by linking your industry recommendations to your deal experience.

Case Studies and Modeling Tests

You will almost always have to complete a case study or modeling test in PE interviews, but the types of tests span a wide range.

Here are the six most common ones, ranked by rough frequency:

Type #1: “Mental” Paper LBO

This one is closer to an extended technical question than a traditional case study.

To answer these questions, you need to know how to approximate IRR, and you need practice doing the mental math.

The interviewer might ask something like, “A PE firm acquires a $150 EBITDA company for a 10x multiple using 60% Debt. The company’s EBITDA increases to $200 by Year 3, $225 by Year 4, and $250 by Year 5, and it pays off all its Debt by Year 3.

The PE firm sells its stake evenly over Years 3 – 5 at a 10x EBITDA multiple. What’s the approximate IRR?”

Here, the Purchase Enterprise Value is $1.5 billion, and the PE firm contributes 40% * $1.5 billion = $600 million of Investor Equity.

The “average” amount of proceeds is $225 * 10 = $2,250, and the “average” Exit Year is Year 4 (no need to do the full math – think about the numbers – and all the Debt is gone).

So, the PE firm earns $2,250 / $600 = 3.75x over 4 years. Earning 3x in 3 years is a ~45% IRR, so we’d expect the IRR of a 3.75x multiple in 4 years to be a bit less than that.

To approximate a 4x scenario, we could take 300%, divide by 4 years, and multiply by ~55% to account for compounding.

That’s ~41%, and the actual IRR should be a bit lower because it’s a 3.75x multiple rather than a 4.00x multiple.

In Excel, the IRR is just under 40%.

Type #2: Written Paper LBO

The idea is similar, but the numbers are more involved because you can write them down, and you might have 30 minutes to come up with an answer.

You can get a full example of a paper LBO test, including the detailed solutions, here.

You can also check out our simple LBO model tutorial to understand the ropes.

With these case studies, you need to start with the end in mind (i.e., what multiple do you need for an IRR of XX%) and round heavily so you can do the math.

Type #3: 1-3-Hour On-Site or Emailed LBO Model

These case studies are the most common in on-cycle interviews because PE firms want to finish quickly.

And the best way to do that is to give all the candidates the same partially-completed template and ask them to finish it.

You may have to build the model from scratch, but it’s not that likely because doing so defeats the purpose of this test: efficiency.

You’ll almost always receive several pages of instructions and an Excel file, and you’ll have to answer a few questions at the end.

The complexity varies; if it’s a 1-hour test, you probably won’t even build a full 3-statement model.

They might also ask you to use a cash-free debt-free basis to simplify the transaction assumptions and adjustments.

But if it’s a 3-hour test, a 3-statement model is more likely. If you do build all three statements, the other parts of the model will be simple.

Here’s an example of a 90-minute LBO modeling test for a European company (blank Excel file here).

There are no 3-statement projections, but there is some complexity in the returns calculations. The full solutions and several other examples are in our Interview Guide:

Type #4: Take-Home LBO Model and Presentation

These case studies are open-ended, and in most cases, you will not get a template to complete.

The most common prompts are:

• Build a model and make an investment recommendation for Portfolio Company X, Former Portfolio Company Y, or Potential Portfolio Company Z.
• Pick any company you’re interested in, build a model, and make an investment recommendation.

With these case studies, you must fit your recommendation to the firm’s strategy rather than building a needlessly complex model.

You might have 3-7 days to complete this type of case study and present your findings.

You might be tempted to use that time to build a complex LBO model, but that’s a mistake for three reasons:

1. The smaller firms that give open-ended case studies tend not to use that much financial engineering.
2. No one will have time to review or appreciate your work.
3. Your time would be better spent on industry research and coming up with a sold investment thesis, risk factors, and mitigants.

I don’t have a great example of an open-ended case study, but the Dell LBO presentation is a good example of the type of recommendation you’d make.

Your model can be far simpler, and the presentation itself can be 3-5 pages instead.

Type #5: 3-Statement/Growth Equity Model

At operationally-focused PE firms, growth equity firms, and PE firms in emerging markets such as Brazil, 3-statement projection modeling tests are more common.

The Atlassian case study is a good example of this one, but I would change a few parts of it (we ignored Equity Value vs. Enterprise Value for simplicity, but that was a poor decision).

Also, you’ll never have to answer as many detailed questions as we did in that example.

If you think about it, a 3-statement model is just an LBO model without debt repayment – and the returns are based on multiple expansion, EBITDA growth, and cash generation rather than debt paydown.

You can easily practice these case studies by picking companies you’re interested in, downloading their statements, projecting them, and calculating the IRR and multiples.

Type #6: Consulting-Style Case Study

Finally, at some operationally-focused PE firms, you could also get management consulting-style case studies, where the goal is to advise a company on an expansion strategy, a cost-cutting initiative, or pricing for a new product.

We do not teach this type of case study, so check out consulting-related sites for examples and exercises.

And keep in mind that this one is only relevant at certain types of firms; you’re highly unlikely to receive a consulting-style case study in standard PE interviews.

A Final Word On Case Studies

I’ve devoted a lot of space to case studies, but they are not as important as you might think.

In on-cycle processes, they tend to be a “check the checkbox” item: Interviewers use them to verify that you can model, but you won’t stand out by using fancy Excel tricks.

Arguably, they matter more in off-cycle interviews since you can present unique ideas more easily and demonstrate your communication skills in the process.

What NOT to Worry About In PE Interviews

The topics above may seem overwhelming, so it’s worth pointing out what you do not need to know for interviews.

First, skip super-complex models.

As a specific example, the LBO models on Macabacus are overkill; they’re way too complicated for interviews or even the job itself.

You should aim for Excel files with 100-300 rows, not 1,000+ rows.

Next, skip brain teasers; if an interviewer asks them, you should drop discussions with the firm.

Finally, you don’t need to know about the history of the private equity industry or much about PE fund economics beyond the basics.

Your time is better spent learning about a firm’s specific strategy and portfolio.

PE Interview X-Factor(s)

Besides the topics above, competitive tension can make a huge difference in interviews.

If you tell Firm X that you’ve already received an offer from Firm Y, Firm X will immediately become far more likely to give you an offer as well.

Even at the networking stage, competitive tension helps because you always want to tell recruiters that you’re also speaking with Similar Firms A, B, and C.

Also, leverage your group alumni and the 2^nd and 3^rd-year Analysts.

You can read endless articles online about interview prep, but nothing beats real-life conversations with others who have been through the process.

These alumni and older Analysts will also have example case studies they completed, and they can explain how to spin your deal experience effectively.

PE Interview Preparation

The #1 mistake in PE interviews is to focus excessively on modeling tests and technical questions and neglect your deal discussions.

You can avoid this, or at least resist the temptation, by turning your deals into case studies.

If you follow my advice to create simplified LBO models for your deals, you can combine the two topics and get modeling practice while you’re preparing your “investor’s views.”

If you’re working full-time in banking, use your downtime in between tasks to do this, outline your story, and review technical questions.

If you only have 10-15-minute intervals of downtime, break case studies into smaller chunks and aim to finish a specific part in each period.

Finally, start preparing before your full-time job begins.

You’ll have far more time before you start working, and you should use that time to tip the odds in your favor.

The Ugly Truth About PE Interviews

You can read articles like this one, memorize PE interview guides, and get help from dozens of bank/group alumni, but much of the process is still outside of your control.

For example, if you’re in a group like ECM or DCM, it will be tough to win on-cycle interviews at large firms and convert them into offers no matter what you do.

If the mega-funds decide to kick off recruiting one day after you start your full-time job in August, and you’re not prepared, too bad.

If you went to a non-target school and earned a 3.5 GPA, you’ll be at a disadvantage next to candidates from Princeton with 3.9 GPAs no matter what you do.

So, start early and prepare as much as you can… but if you don’t receive an offer, don’t assume it’s because you made a major mistake.

So You Get An Offer: What Next?

If you do receive an offer, you could accept it on the spot, or, if you’re speaking with other firms, you could shop it around and use it to win offers elsewhere.

If you’re not in active discussions with other firms, you’re crazy if you do not accept the offer right away.

If You Get No Offer: What Next?

If you don’t get an offer, follow up with your interviewers, ask for feedback, and ask for referrals to other firms that might be hiring.

If you did reasonably well but came up short in a few areas, you could easily get referrals elsewhere.

If you did not receive an offer because of something that you cannot fix, such as your undergraduate GPA or your previous work experience, you might have to consider other options, such as a Master’s, MBA, or another job first.

But if it was something fixable, you could take another pass at recruiting or keep networking with smaller firms.

To PE Or Not to PE?

That is the question.

And the answer is that if you have the right background, you understand the process, and you start preparing far in advance, you can get into the industry and win a private equity career.

And if not, there are other options, even if you’re an older candidate.

You may not reach the promised land, but at least you can blame it on someone else.

Additional Reading

You might be interested in The Search Fund Internship: Perfect Pathway into Investment Banking and Private Equity Roles?.

The post Private Equity Interviews 101: How to Win Offers appeared first on Mergers & Inquisitions.

And your bank account is set to get even fatter in the future – if you can successfully break into private equity.

While you know about the case studies and modeling tests you’ll get and the deals you’ll have to discuss, you haven’t put any thought into the “Why private equity?” question.

Which is a problem – because the last thing PE guys want is a banker or consultant who wants to do PE simply because he/she hates banking or consulting or because everyone else doing it.

Why Private Equity: Why Does It Matter?

While PE firms want people who are technically proficient (one reason why consultants face a more difficult time getting in, at least in the US), fit is even more important than in banking because firms are an order of magnitude smaller.

Whereas the top banks have tens of thousands to hundreds of thousands of employees, the biggest PE firms in the world only have a few hundred – and there are thousands of PE firms with fewer than 10.

Unlike banks, private equity firms have no need to hire an army of analysts to do grunt work: they’re not creating pitch books and competing for sell-side, buy-side, and financing mandates all day, and if they’re understaffed they can say “no” to potential investments.

The interview process can also be much more of an extended affair in PE, with many firms below the mega-fund level conducting interviews over months rather than the days or weeks you see in banking (the mega-funds do it much more quickly).

As a result, fit is critical and if the Partners doubt your motivations for wanting to do PE, they won’t give you an offer.

What NOT to Say for the “Why Private Equity?” Question

As with some other interview questions, there’s a temptation to say something stupid in response to “Why private equity?”:

• “I don’t like the hours in banking, and I want a better lifestyle.”
• “You can make much more money in PE because you’re an investor rather than an advisor!”
• “Well… all my friends are doing it!”
• “I want to control companies rather than taking orders from my MD all day.”

I doubt you would say anything this bad in a real interview, but your actual answer may not be significantly better, either.

All the reasons above are bad answers, for different reasons:

• While the lifestyle may be a bit better at smaller firms, it’s still far from a 9-5 job. And at mega-funds it’s banking all over again.
• The pay is also not that much better, especially when you first start. Yes, Steve Schwarzman makes more than any MD in banking but he’s also the Co-Founder of the best-known and oldest PE firm in the world, with 30+ years of experience.
• If you want to become an investor, you want to demonstrate independent thought as opposed to following what all your friends are doing.
• You don’t “control” companies as an analyst or associate, you manipulate spreadsheets.

In short, any variant of “I don’t like my current job and PE would be better because [Insert Reason Here]” is bad because it’s too negative.

And anything where you sound like you expect to conquer the world and become a trillionaire also sounds bad because it shows that you don’t have a clue about how the industry works.

Private Equity: The Promised Land? Fact and Fiction…

You might have had dreams of becoming a baller at KKR or Blackstone making $100 million per year, but you should pinch yourself and wake up since that will never happen.

I often group IB and PE together on this site because the work is not much different.

If you don’t like Excel, if you think EBITDA is boring, or if you have no interest in analyzing financial statements or reading about different companies, you should stop right now and do something more creative like advertising instead (I hear Don Draper is hiring…).

There are advantages and your role differs from what you do in banking, but if you fundamentally do not like analyzing and valuing companies, you’re going to hate it.

You do get more responsibility at certain firms, sometimes you’ll get to observe Boards of Directors and sit in on meetings, and you don’t get the stupid fix-the-printer-and-fetch-coffee tasks that you see in banking.

But please do not assume that it’s a night-and-day difference just because a bunch of 22-year old students in your finance club say it is.

Better Answers to This Question

To answer this question successfully, you need to avoid the clichés above and point out positive differences between PE and banking or between PE and whatever you’re moving in from (consulting, corporate development, etc.).

But you need to do that by highlighting what you’re looking for rather than what you don’t like about your current job.

Examples of solid answers to the “why private equity” question:

• You want to work with companies over the long-term instead of just on a single deal.
• You want to get exposed to the operations of companies and understand all aspects rather than just the financial ones (note: “exposed to,” not “control” or “improve”).
• You want to contribute to companies’ growth by looking at bolt-on acquisitions and other expansion opportunities that only an investor would be able to execute.
• You see yourself as an investor in the long-term, and want to learn all aspects of the process and how to evaluate whether a company can deliver solid returns.

It’s not “wrong” to make a direct comparison between PE and other fields (see the first 2 reasons) but you always want to downplay the negative part.

Ideally, you’ll tie the investments a PE firm makes to what you’ve done previously in school or work:

• The engineer-turned-banker has a much better story to tell if he recruits for a tech PE firm or growth equity firm and explains how he’s interested in applying his knowledge of IT and finance to investing in IT companies.
• If you’ve worked in Restructuring or Distressed M&A, you have a much better story if you recruit for a firm that specializes in turnarounds or distressed investments.
• If you’ve done consulting for restaurants or food chains, you’ll have a much better story to tell when you recruit for a PE firm that specializes in those types of investments, or even in the consumer sector as a whole.
• If you’ve done corporate development at a media or broadcasting company, you’ll have a much better story to tell when you interview with Bono at Elevation Partners.

The exact reasons depend on your background and where you’ve worked before, but you should combine these points – industry / company / deal focus + investing and working with companies in the long-term – to frame your answer:

• The banker would talk about how he wants to work with companies over the long-term and learn how to assess whether they can deliver solid returns so that he can become an investor in the future.
• The consultant would talk about how he wants to learn both the financial and the operational aspects of companies, and how he wants to be involved with decisions that a company implements rather than just recommendations.
• The corporate development guy/girl would talk about how he/she wants the opportunity to work with all different types of companies in the market rather than just one.

It’s not rocket science: highlight the positive differences between PE and your current field and why you’re interested in pursuing them as you transition into becoming an investor yourself.

If you’re coming from a banking or consulting background, you may get questions about PE vs. other exit opportunities:

Why Private Equity Over Venture Capital?

If the PE firm you’re interviewing with asks you this one, say that VC is too far in the operational direction for you, and how you feel it’s more about predicting the next Google/Facebook/Zynga than analytical reasoning.

You prefer PE because it’s a blend of both operations and finance and because you can help Founders with well-established businesses make them even better via solid analysis and research rather than just guesswork.

And, of course, if you’re interviewing for VC you want to take the opposite position and say that PE is all about financial engineering with little value-add and that you can truly help early-stage companies take off because they’re more in need of help than established ones.

Why Private Equity Over Hedge Funds?

For detailed coverage of this topic, please see our article on the hedge fund vs private equity comparison.

In short, this one is harder to answer because there are so many types of hedge funds, and the strategies used and the fund sizes can make for completely different experiences.

But the main difference between most hedge funds and most PE firms is that in PE you invest in entire companies (at least, in developed markets) whereas at hedge funds you make much smaller investments and it’s often closer to trading.

You prefer PE because you want to understand how entire businesses work – at a hedge fund you would only get the financial aspect and your skill set would be more limited.

Why Private Equity Over Corporate Development?

This one also has a more subtle distinction: the main difference is that in PE you look at all sorts of different investment opportunities and companies, whereas in corporate development the scope is more limited and you’re always looking at deals and partnerships for your own company.

So that’s exactly what you say in your answer: you want to gain a broader horizon and work in industries and sub-industries outside your own.

You’re more likely to get this type of question if you’re already in a corporate development role and you’re moving into PE – as a banker or consultant it’s not terribly likely unless you say you’re also interviewing for corporate development jobs (um, don’t do that).

Are Any of These Reasons True?

I mentioned above that many of the myths about PE (becoming a baller making $100M USD at age 25, buying countries, and surpassing deities) are untrue.

For all these “Why PE” examples I’ve been referencing the mix of operational and financial work and working with companies over the long-haul – so you might rightfully wonder if any of that is true.

It’s somewhere in between: some firms do focus more on add-on acquisitions and operational improvements, whereas others really are just about financial engineering and using as much debt as possible to boost returns.

Even if the firm you’re interviewing with is more focused on finance, though, you will still learn more about operations because you do a ton of due diligence before you actually invest (in banking you mostly just send these documents to other parties).

Unless you start or work at a real company, you’ll never learn the ins and outs of how it “really” works, but you will at least learn more than you would as a banker – so it’s more true than the bad “Why PE?” answers in the beginning.

Why Private Equity?

Hopefully not because you have delusions of grandeur and you’re planning out which beach in Thailand you’ll buy with your first $10 million.

Focus on the positive differences, link your reasons to your background and long-term goals (just like with the “Why investment banking?” question), and don’t fall prey to any of the bad answers about pay or lifestyle.

For Further Reading:

• Private Equity Industry Overview
• How to Ace Your Private Equity Interviews
• How to Get Into Private Equity: Step-by-Step Guide
• Investment Banking Exit Opportunities: The Myth Of The Buyside Job
• Private Equity Case Studies in 3,017 Words
• Private Equity Resumes
• Private Equity Salary, Bonus, and Carried Interest Levels: The Full Guide.
• The Complete Guide to Technology Private Equity.

The post Why Private Equity? appeared first on Mergers & Inquisitions.

Anyone who’s ever traded stocks can understand long/short equity, and even simple global macro trades are easy to explain to the average person.

But if you invest in credit and try to explain your job to a normie, their eyes will glaze over as you talk about credit default swaps, crossover credits, or the springing maturity date found on page 374 of a loan agreement.

This complexity and the need to understand legalese mean that credit investing is less accessible to the average person.

But if you have the right knowledge and experience, credit hedge funds can provide a great career path:

What is a Credit Hedge Fund?

Credit Hedge Fund Definition: Credit hedge funds buy and sell fixed-income securities, such as high-yield bonds, distressed bonds, structured credit, and their derivatives; they profit by setting up trades that reduce one type of credit risk while betting on mispriced securities whose prices are likely to change in the future.

This definition already feels difficult to understand, so a quick example might help.

The simplest example of a long/short credit trade is to long one bond and short a similar bond issued by a peer company.

In other words, you buy one bond to earn the interest it pays and sell it if/when its price increases, and you borrow another bond, sell it, pay the interest coupons to the counterparty, and buy it back if/when its price decreases.

Let’s say that Target has a bond with an 8% Yield to Maturity, i.e., you earn an internal rate of return (IRR) of 8% if you buy the bond at its current market price and hold it until maturity.

Walmart, a peer company, has a similar bond, but its YTM is only 5%, even though the terms, seniority, and maturity are similar.

So, you long the Target bond and short the Walmart bond.

You’ll earn interest on the Target bond and will have to pay interest on the Walmart bond.

You could close out this trade in several ways:

• Hold Until Maturity – Assuming that neither company defaults and the 3% spread does not change, even if overall interest rates do, you’ll earn an annualized return equal to the YTM of Target Bond – YTM of Walmart Bond – Short Sale Costs.
• Sell/Buy When Prices Change – For example, maybe company-specific factors result in the YTM of the Target bond falling to 6%, meaning its market price has increased. The Walmart bond’s YTM is still 5%, so its market price is the same. You could now sell the Target bond and buy the Walmart bond to close your short position, and you would profit based on the initial spread, the increase in the Target bond’s market price, and the short sale costs.

This may not sound like a great result because it’s less than a ~3% annualized return.

But you can boost the results with leverage, and if the price change in the second scenario happens over a few months, it might result in a much higher return.

You might also look at this trade and say, “Wait a minute. Why would you short the Walmart bond? Wouldn’t you earn more simply by longing the Target bond to get the 8% yield?”

Yes, you would earn more in a favorable credit environment (falling rates), but this trade aims to hedge one type of credit risk.

The three traditional credit risks are default risk, credit spread risk, and illiquidity risk, and with structured credit, there’s also default correlation risk.

With this trade, even if overall interest rates change, meaning that both bonds’ market prices change, we’re still fine as long as the spread stays at 3%.

We’re betting that company-specific factors will change each bond’s price.

If we purchased the Target bond without shorting the Walmart bond, we would be exposed to company-specific and interest-rate risk: if overall interest rates rose, the bond’s market price would fall.

There are hundreds of possible credit trades, but a few simple examples include:

• Synthetic Long/Short – You make the same trade as above, but you use credit default swaps instead of the underlying bonds. You profit if you can sell protection on one bond for a higher price than you pay for protection on the other bond.
• Long a Longer-Term Bond and Short a Shorter-Term Bond – For example, if Target has a 10-year bond with an 8% YTM and a 5-year bond with a 4% YTM, you could long the 10-year bond and short the 5-year bond and bet that longer-term yields will remain above shorter-term yields.
• Long a Credit Pool and Short Specific Tranches – For example, you could long a mortgage-backed security pool but bet against specific tranches by shorting them or using CDS.

Types of Credit Hedge Funds

To simplify, we can say that credit hedge funds operate in three main areas:

1. Long/Short Credit – It’s similar to long/short equity, but with bonds rather than stocks. See the example above.
2. Structured Credit – Now you’re buying or selling pools of similar debt obligations rather than single securities or derivatives. See the Structured Finance article for more; subcategories include mortgage-backed securities (MBS), asset-backed loans (ABL), and collateralized loan obligations (CLO).
3. Distressed – The main difference is that the range of possible outcomes is much wider; similar to distressed private equity, a hedge fund could trade the distressed bonds, or it could use them to gain influence or control eventually.

Here’s how Preqin divided up the credit hedge fund universe (old data but still directionally correct):

“Investment-grade bonds” are not an explicit category because it’s much harder to find significantly mispriced securities in that space.

Besides these categories, we can divide most credit hedge funds into trading vs. investing.

• “Trading”-Focused Funds: These trade more-liquid credits, hold more positions (50-100+), use shorter holding periods, and use more leverage to amplify their returns. Often, they aim to profit from macro moves such as changing interest rates while hedging company-specific risk.
• “Investing”-Focused Funds: These trade less-liquid credits, hold fewer positions (perhaps 10-15), and use longer holding periods. These funds tend to favor distressed or stressed bonds and attempt to profit via fundamental changes in the issuer’s credit profile while hedging interest-rate risk.

Credit hedge funds share some traits with direct lenders, mezzanine funds, and distressed private equity firms, but they also differ in important ways:

1. Primary vs. Secondary Issuances – Direct lenders and mezzanine firms fund companies directly, i.e., they purchase their debt when the company issues it at the issuance price. But credit hedge funds usually purchase bonds in the secondary market after the prices have changed significantly, and they bet on changes in these prices.
2. Flexibility – Most direct lenders and mezzanine funds operate in a “loan to own” mentality, where the goal is to hold an issuance until maturity or change of control. By contrast, credit hedge funds can do almost anything, from long-term holding to long/short trades to complex trades involving derivatives.
3. Security Types – Other credit firms tend to focus on specific types of fixed income, such as mezzanine. Even distressed PE firms focus on the “fulcrum security” (the one most likely to be converted into equity in a bankruptcy process). But credit hedge funds could trade almost any type of credit.

There is a good amount of overlap between distressed hedge funds and distressed private equity firms.

The main difference is that PE firms are more likely to pursue control strategies that result in significant equity stakes or to gain influence in the restructuring/bankruptcy process.

What Makes Credit Hedge Funds Different?

This article from Barclays has some useful graphs, and the one with returns from 2000 – 2019 and 2010 – 2019 sums up the advantages of credit funds quite well:

In terms of other criteria/features:

1) Liquidity – This one varies by the trading vs. investing distinction, but credit hedge funds tend to offer less liquidity and longer lock-up periods than strategies like equities and global macro (but less so than activist investing).

2) Time Horizon – It could be days/weeks/months for trading-style funds or multiple years for funds that focus on distressed bonds.

3) Low-to-Moderate Leverage – The average credit fund uses far less leverage than a global macro fund and a bit less than the average equity fund.

Finally, credit funds tend to incur higher startup costs and require a higher AUM than other fund types because of the extra employees and outside services required.

For example, to process and check loan documents efficiently, you’ll have to pay for covenant-review services or lawyers.

So, if you are crazy enough to start a hedge fund, a credit fund is not exactly “DIY-friendly.”

The Top Credit Hedge Funds

Almost all the large hedge funds and private equity mega-funds are active in credit.

So, you’ll see well-known names like Ares, Elliott, Oaktree, and Cerberus at or near the top of most lists.

Many of these funds do everything from direct debt origination to specializations in areas like non-performing loans (NPLs).

If you want a list of smaller hedge funds that are known for their credit investing, here it is: Anchorage (now partially shut down), Angelo Gordon, Arbour Lane, Avenue, Bracebridge, Brigade, Canyon, Capula, Centerbridge, GoldenTree, Gramercy, Ellington, King Street, Magnetar, MJX, Saba, Silver Point, Symmetry, and Varde Partners.

Some firms on this list, like Saba, are more trading-oriented, while others, like Canyon, take more of a fundamental / “deep value” approach.

Who Gets Into Credit Hedge Funds?

To win offers at credit hedge funds, you need experience analyzing, trading, or investing in debt. In practice, that means:

• Any investment banking group that does a lot of debt issuances, including many industry groups and Leveraged Finance, but probably not DCM (less analysis).
• Credit research, either on the sell-side or the buy-side.
• Certain trading desks, such as rates trading or distressed debt.
• Credit rating agency experience.
• And, in theory, other credit-related roles such as direct lending, mezzanine, and distressed private equity.

Here are the most common backgrounds I found when looking up professionals currently working at credit hedge funds on LinkedIn:

• Investment Banking: 37%
• Sales & Trading: 23%
• Other Hedge Fund / Asset Management Roles: 23%
• Investment Banking + Private Equity: 7%
• Credit Rating Agency: 7%
• Research: 3%

If you have a trading background, you’ll be competitive for trade execution roles at investing-oriented funds and possibly for investment roles if you target a strategy like relative value or fixed-income arbitrage.

Otherwise, if you want to work at research/investing-oriented firms, you’re better off in a credit-heavy IB group or as a credit desk analyst in S&T doing the research.

I could not find many direct examples of people who worked in roles like direct lending and mezzanine and then joined credit hedge funds, but it seems possible if you target the right strategies.

It might just be that people in these roles are more interested in traditional private equity.

Interviews, Case Studies, and Credit Pitches

You can expect questions similar to the ones in a LevFin, DCM, or Restructuring interview, but they’ll be framed in terms of your views as an investor.

For example, they might ask you to explain a credit’s strengths and weaknesses and whether or not you would invest based on limited information.

They could also ask you why different credits might trade differently despite similar profiles.

For example, why might Bond A have a 10% YTM with an 8% coupon rate while Bond B has a 9% YTM with a 10% coupon rate if they have the same ranking in the capital structure?

The most obvious answer is different maturities, but liquidity/size (smaller issuances are less liquid), call protection, or different covenants might also explain this.

It also helps to know about CDS, options, and various credit indices (the BofA High-Yield Index, the LCDX, the LSTA 100, etc.) so you can use them to construct trade ideas.

Finally, especially for research-oriented funds, you should know the terms in credit agreements very well, ranging from covenants and change-of-control clauses to “Restricted Payment” (RP) baskets. There’s a good summary here.

For open-ended case studies (they tell you to find a company and credit), the easiest strategy is to do the following:

1. Read up on significant events that might act as catalysts, such as potential M&A deals, management shakeups, divestitures, and asset sales, and see if the companies in question have debt. You can search sources like the WSJ or FT to get ideas. Start with “potentially troubled companies” rather than specific issuances.
2. Do a quick debt analysis, focusing on senior notes through the mezzanine and preferred stock. If you don’t see a potential mispricing (e.g., the YTM on two bonds is similar even though one is subordinated to the other), move on. Otherwise, keep going.
3. Create several simple scenarios, such as what happens to the bonds if the company refinances successfully vs. its business declines and it can’t refinance vs. the company gets sold in an M&A deal. For distressed companies, you can consider alternatives like a debt-for-equity swap, liquidation, or DIP financing.
4. Use the output of the scenarios to argue that one or more of the company’s bonds is mispriced and could change in the future due to the catalysts you found in Step 1. For example, you could argue that in a standard refinancing or debt-for-equity swap, Bond A is undervalued by 15-20%; investors would lose money only in a full liquidation, which is extremely unlikely.

Recovery analysis will be a key part of almost any case study because you always focus on the chances of losing money in credit recommendations (example below for real estate):

You could easily have a “good business / bad credit” case or a “bad business / good credit” case, and you must be able to articulate why, such as a large value gap between first-lien and second-lien loans.

Credit Hedge Fund Careers

Not much in this section is specific to credit hedge funds, but I will point out a few differences:

• Schedule / Lifestyle – Expect the standard 60-70 hours per week at hedge funds, with longer hours during earnings season or “busy issuance season.” The need to follow new debt issuances and not just corporate earnings can make your average hours longer, especially at trading-oriented funds.
• Team / Culture – Credit investing tends to be more of a “team sport” than other strategies because you often depend on other groups for data and pricing information, and you may even hire an outside firm to review loan documentation. And if you’re a trader, you depend on the research team to dig into companies’ filings.
• Moving Around Within Credit – It’s easier to move from distressed to high-yield or structured credit than to do the reverse, and it’s far easier to move from distressed to investment-grade than to do the reverse.

Exit Opportunities

As with other hedge funds, reverse the entry points to determine the exit opportunities.

If you leave a credit hedge fund, you could move into many other credit-related roles, from direct lending to mezzanine to the credit platforms at the mega-funds.

You could potentially even go back to a role at a large bank, but few people do that willingly.

It’s more useful to point out the unlikely exit opportunities.

First, you probably don’t have a great shot at private equity unless you’ve already worked in it – or you’ve worked at a distressed fund, and now you’re aiming for distressed PE funds.

Some credit analysis is involved in private equity, but everything tends to be more process-oriented and geared toward long-term holding.

Second, you don’t position yourself very well for roles at normal companies, such as corporate development and corporate finance, because the skill sets are not related.

Finally, credit hedge fund roles are unlikely to lead to venture capital; even something like venture lending is a stretch because the analysis and deal work is quite different.

For Further Learning

• The Handbook of Fixed Income Securities – The Fabozzi classic; still useful for learning/reviewing the fundamentals.
• Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives – More useful for trading.
• Distress Investing – If you’re more advanced (written by a famous distressed investor and a professor).
• Distressed Debt Analysis – The classic Moyer guide.
• Corporate Financial Distress, Restructuring, and Bankruptcy – For an overview of everything.
• com for good-but-expensive credit data; you can follow their Twitter account for free webinars and case examples.
• The Distressed Debt Investing Blog – No longer actively updated, but the older information and examples are all still useful.

Credit Hedge Funds: The Final Verdict

I don’t think credit hedge funds are the best choice for everyone, but they are one of the more overlooked areas.

Part of the problem is that many courses give the impression that credit analysis is “boring” because the examples mostly deal with investment-grade bonds.

But high-yield bonds, distressed bonds, and structured credit are significantly more complex.

And although you focus on credit analysis, you need to understand entire companies and have views on entire capital structures, which means the job also involves equity analysis.

You can also get into the industry from many different roles, so it’s less restrictive than something like activist hedge funds or even global macro.

Some people also argue that the “pay ceiling” at the top levels is lower than at other fund types due to lower fees, higher overhead, and more predictable performance, but I could not find much real data to back up that claim.

And even if it were true, I don’t think the pay differences would matter much after a 10 or 15-year career.

So, I think the biggest issue with credit funds is accessibility.

It’s extremely difficult to “learn” how to read a long loan document independently, and it’s not viable to trade most bonds in your personal account because the denominations being traded are quite large.

So, you normally have to get real-world experience in credit and use that to move in.

But if you can do that, credit hedge funds might offer one of the best career paths.

Want more?

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