Top 1L: Lucrative elevators
Why you must consider law firms with booming private equity practices
Top 1Ls,
We hope this week was better than the last. If you need to change things around, start small and keep at it. Over time, these incremental changes will add up and you’ll achieve amazing things. We hope you enjoy this week’s newsletter.
If you want maximum success in Biglaw, you absolutely must understand Biglaw’s clients and their businesses. And one of Biglaw’s most important clients come from one industry: private equity, an exclusive segment of high finance.
This is why we start with Europe’s hottest M&A deal, where some of the biggest private equity players are circling a German industrial company. From there, we explain core aspects of private equity that will provide you with a nuanced understanding of the industry that, unfortunately, many 1Ls will not possess until it’s too late.
Don’t be that person. Instead, read on.
Would you invest in elevators?
As reported by various media outlets, some of the top private equity firms are currently engaged in a four-way bidding war with bids of up to about $19 billion (USD) (Reuters, NYT, FT, Bloomberg).
For what?
None other than… Elevators.
That’s right. Three private equity consortiums are trying to buy the elevator division of Thyssenkrupp AG, a German industrial conglomerate. One consortium is led by Blackstone and Carlyle, two of the top names in private equity. Another is led by Advent and Cinven, who are teaming up with sovereign wealth fund Abu Dhabi Investment Authority. The last is led by Brookfield, another giant in the alternative investment world. A Finland-based elevator maker, Kone, is also teaming up with private equity shop CVC Capital, as they try to outbid the rest in hopes to acquire the elevator division.
So why do billionaires care about elevators?
Maybe you know already that some of the wealthiest people in the world made their names in private equity.
Take a look at the legendary co-founder of Blackstone, Stephen Schwarzman. According to the Bloomberg Billionaire Index as of earlier this week, Schwarzman has a net worth of over $20 billion.
So how does someone like Schwarzman become so wealthy by buying up elevator makers?
The answer to this question gets to the heart of why you should consider pursuing law firms that have a deep private equity practice. The answer has three prongs:
Leverage
The 2 and 20 Model
Tax Treatment
Leverage
The world of private equity is characterized first and foremost by one persistent, key feature, leverage.
Leverage is basically borrowed money. The ability to borrow capital for investment lies at the core of private equity and is what drives wealth generation for alternative investment managers.
To understand the impact that leverage can have on investing in the private equity world, let’s play with some numbers:
Scenario 1: Let’s say you have a crisp 100 dollar bill. You invest it in such a way that generates 5% after a year, at the end of which you will have $105. You made $5. Not bad, right?
Scenario 2: Now imagine a different scenario where you have the same $100 bill, but because you’re a private equity shop, your bank lets you borrow $900 on top of that. Now you have $1,000 to invest. You invest it in the same 5% yielding investment. After one year, you have $1050. After you pay back the borrowed $900 to the bank, you have $150. Given that $100 of it was your own money initially, you made $50. Congrats! That’s a lot more than the $5 you made without borrowing from your bank friends. In fact, it’s TEN times as much.
This is a crude example, but it shows the huge impact that borrowed money can have on investing. It doesn’t contain many important details, like how much the bank will charge in terms of interest and fees. But all things considered, the fees and expenses that private equity funds pay to lenders and external service providers don’t alter the fact that the business of private equity can drastically enhance the return profile of an investment by employing leverage (this is especially true these days when interest rates are at all-time lows around the world).
With borrowed capital, you can make a boring 5% yielding investment (maybe one that makes elevators) into one that yields 50%, making the investment TEN times more profitable. Now you can see why private equity shops may be drooling over the prospect of acquiring the Thryssenkrupp elevator division.
But there’s more to this story that makes the potential payoff even bigger for private equity professionals like Schwarzman.
2 and 20
In addition to leverage, there is another structural factor in how private equity managers like Schwarzmann can supercharge their wealth. It relates to how the money flows differently to whom, depending on whether the realized risk is downside or upside in nature.
To understand this better, you have to know that at Blackstone, it’s not just Stephen Schwarzman’s money that’s used for investing. In private equity, the initial $100 used in Scenario 2 above doesn’t come from just private equity managers like Schwarzman. Most of Blackstone’s private equity funds have external investors like sovereign wealth funds and pension funds that invest huge amounts of capital into them, in hopes that managers like Schwarzman will generate great returns. In fact, capital from external investors commonly exceeds the money from private equity professionals by many, many times. While we can’t discuss specific details of any funds we were involved in, it may not be very odd to see just $1 of the $100 be PE professionals’ own money and find $99 of it to be external investors’.
First the “20”
Now Top 1L readers, here’s the tricky part that your other 1L colleagues won’t know:
It’s the combination of leverage and how the realized risk is shared across the private equity professionals on the one hand and external investors on the other that makes private equity so lucrative for its professionals.
This is how it generally works:
When an investment turns out to be a money-losing one, everyone suffers, somewhat equally.
However, it’s when the private equity fund hits a homerun with its investments that things become very different. Instead of sharing in the upside rewards equally, a disproportionate share of the upside goes to private equity professionals like Schwarzman. Specifically, under what is commonly referred to as the “2 and 20” compensation model, 20% of the returns that would be attributable to an external investor’s capital actually goes into the pockets of private equity managers.
Let’s do some math again and focus on how the “20” part of the 2 and 20 model works numerically.
In Scenario 2, the one with leverage, the initial $100 netted $50 after paying off the bank. Now let’s alter the hypo a bit:
Scenario 3: Let’s say there is a private equity fund manager called Jack. And to reflect the reality of external investors, let’s say that $99 of the initial $100 was external investors’ money that was given to Jack to manage, and only $1 of it was Jack’s. With leverage (the bank lets Jack’s fund borrow $900), the investment nets the same $50 as in Scenario 2. Now, technically speaking, since only 1% of the initial $100 was Jack’s, only 1% of the $50 return is attributable to Jack ($0.50) and 99% of it - $49.50 - is attributable to investors.
Not so fast, say Jack’s lawyers.
Under the 2 and 20 compensation scheme, however, Jack is actually entitled to receive 20% of the upside attributable to the external investor’s capital. So instead of getting $0.50, Jack receives that plus another 20% of the $49.50 that was technically attributable to external investors (which is $9.90). So he goes home with a total of $10.40. Starting with $1 of his own money, through his private equity fund, our friend Jack now has an extra $9.40. That’s an astounding 940% return.
Let’s make the hypo feel more real. Let’s say every dollar actually represented ten million dollars. So after investing just $10 million of his own money, Jack goes home with a handsome sum of $104 million with $94 million of it being new money that’s now his.
Under the new scenario, it turns out the pension funds and sovereign wealth funds have made out with an effective return of about 40% on their money after paying Jack his 20%. While it pales in comparison to the 940% return Jack will enjoy, external investors are happy because in a world with underfunded pensions threatening to destroy the fabric of society, such returns will make them clamor for more. When Jack’s firm launches its next fund, those same investors will come back and commit even more capital.
(For more on this topic, take a look at this Investopedia article, which takes a deep dive into carried interest, which is the industry term used to describe Jack’s 20% compensation in our hypo.)
Don’t forget the “2”
So far, we’ve discussed only the 20 part of the “2 and 20” model.
The 2 part in “2 and 20” stands for the contractual obligation on the part of investors to pay 2% of the assets under management as a management fee, on an annual basis. This 2% is paid regardless of how the private equity fund performs. Even if Jack’s fund performs terribly, his company will generally still gets the 2% every year.
How awesome is that?
But wait, there’s more!
Favorable tax treatment
There is another structural reality that just makes everything even better. Through what is commonly referred to as the ‘carried interest loophole,’ much of the income that private equity professionals make from their funds are taxed at significantly lower rates than the rates paid by normal wage-earners.
Not only can Jack make significantly more money on his invested capital with leverage, but he will also pay a significantly smaller percentage of tax to Uncle Sam on that amount when compared to many others.
Get the bigger picture
Granted, things are constantly changing in the private equity world and any lawyer will tell you that there is no absolute rule that applies across all situations. For instance, instead of 2 and 20, the compensation scheme might actually be 1.5 and 15, depending on the size of the fund, the negotiating power of the private equity fund manager and the market environment. In some cases, if there are losses on investments, managers with less negotiating power will bear much more of the downside than others. And again, the example we made up is oversimplified missing many critical details.
If you ever become a funds lawyer, your job will be to obsess over all of these details and help your clients negotiate in their favor.
However, Top 1L readers, for now those details shouldn’t get in the way of your goal to identify what law firms you should be spending your valuable time and energy on, based on what is - by and large - true about the reality of Biglaw.
And generally speaking, the combination of leverage, favorable compensation schemes, and highly advantageous tax treatment just make the world of private equity extremely lucrative.
Private equity and the business of Biglaw
So what kind of business will a private equity firm generate for its Biglaw friends? While we can’t predict how the Thryssenkrupp deal will play out, here’s a hypothetical narrative, many parts of which are not uncommon in private equity, illustrating why private equity is so important for Biglaw. Basically, private equity clients generate a crazy amount of business and revenue for law firms that specialize in their industry and they do so year after year, on a repeated basis:
Investment Funds and Tax Lawyers
Remember that most of the money in Jack’s fund came from external investors, who won’t just wire money without contractual rights. They’ll want to negotiate terms with Jack and put everything in writing. Hence, Jack needs the help of Investment Funds Lawyers and their sidekicks Funds Tax Lawyers who specialize in negotiating with these sovereign wealth funds and pension funds.
M&A Lawyers
While his funds and tax lawyers were negotiating with his investors to get the capital in, Jack and his team have been diligently circling the world to identify potential targets where the deployment of that capital would provide the best returns. Jack and his team will enlist the help of a large number of M&A Lawyers in conducting extensive legal and business diligence on a select few of these targets. If Jack decides to bid on the company and wins the bid, a thick and long stream of revenue will result by way of M&A legal advisor fees as they work on the M&A transaction.
Leveraged Finance Lawyers
As Jack and his M&A Lawyers hone in on a specific target, Jack’s team reaches out to its Leveraged Finance Lawyers to negotiate terms in connection with the capital they will borrow from their favorite investment bank for the M&A transaction.
Exec Comp Lawyers
After Jack’s fund buys the target company with the help of its M&A Lawyers, they decide to place their own executives at the company and provide the execs with compensation terms that strongly incentivize them to reach financial goals. Jack’s team will call on the services of its Executive Compensation and Benefits Lawyer, to structure and document the arrangement.
Litigators
This executive team then decides to fire a large number of employees as a part of a restructuring program in pursuit of these financial metrics. Those fired employees have now sued the company, Jack and his team. Jack will enlist the help of his Litigation Lawyers who will work tirelessly to defend the company and his team, on this critical matter that has become a headache for Jack as he pursues his 2 and 20.
Capital Markets Lawyers
After a few years of managing this company, Jack’s executive team has achieved the financial metrics in their contracts, making the company as profitable as ever (while also enriching themselves by way of restricted stock). Thanks to the litigators, the lawsuit has settled. It’s time to exit and realize the returns that everybody has been waiting for. Jack and his team decide they want the portfolio company, which has been privately owned by Jack’s fund, to do an initial public offering on the New York Stock Exchange. Jack, his team and the portfolio company execs will work with the Capital Markets Lawyers to make this happen.
Trusts and Estates Lawyers
After the IPO, Jack is now very wealthy. He figures he needs to have a will and create some trusts for his kids. A Trusts and Estates Lawyer will be lucky to get a call from Jack.
And repeat…
After a quick vacation, Jack is back in the market again looking for targets. And the whole process starts again.
Key takeaways for your career
Private equity clients are some of the most incentivized professionals in the world with multiple structural advantages that we examined above. These structures motivate them to aggressively pursue targets and make deals happen on a repeated basis. The highly transactional and bold nature of the private equity industry means that private equity fund managers are a fantastic client group to have from the perspective of law firm business generation, extensively impacting multiple practice areas.
So Top 1L readers, even if you’re not interested in M&A, joining a law firm with a good private equity client base could be a very good move. Such firms will have a substantial amount of client work that will help you build out your legal career whether it be in funds, finance or litigation. Of course, if you are interested in M&A, ignoring the law firms that have a good private equity client base may result in some serious regret, regardless of where you are in the grade spectrum.
With the private equity industry raising a record $300 billion in capital in 2019, most of which has yet to be deployed, the future will likely hold even more business for law firms with expertise in this area. According to McKinsey, the private equity industry has grown seven-fold since 2002. It will likely continue to grow, providing ample ground to build out a legal career.
Law firms
Per Chambers and Partners (and our experience generally corroborates their research) the undisputable leaders include Kirkland & Ellis and Simpson Thacher. Other firms with thriving practices include Latham & Watkins, Ropes, Cleary Gottlieb, Debevoise, Paul Weiss and Weil Gotschal. Firms such as Proskauer and Goodwin Proctor also have fantastic mid-market private equity practices.
As we recommended last week, even if you spend just a few minutes doing research or sending out emails to attorneys at these firms, we highly recommend that you document your effort in detail, in a format that will be accessible at later times.
Don’t let this happen to you
We want to close this week’s newsletter with one word of caution. It is based on our many years observing many attorneys who have struggled with their paths.
The world of Biglaw has more law firms than you have time for, especially as a 1L. If your school has an on-campus interview program, you and your fellow 1Ls will be asked to rank them, bid for them and interview with them this summer, without really having been provided the opportunity or guidance to conduct sufficient research on most of them. It will be a frantic and confusing process. There will be very few 1Ls with a sharp focus on the law firms that provide the most opportunity. Most of them will end up spending their valuable bids on firms they should have zero interest in, just because they heard from other people or Vault Rankings that those firms were good ones.
Several years into their careers, these same people will hit a wall. They realize that Vault Rankings aren’t everything. Even if they’re at prestigious firms, they find out that prestige means nothing without a sound book of business that generates multiple lines of revenue. They make desperate efforts to lateral to firms that look better in light of their newfound but undeniably belated understanding of how the world of business works.
We saw this play out many, many times. The tragedy started when those attorneys were 1Ls, just like you. Unfortunately, the system doesn’t help 1Ls. The system just wants you to get a job, not the job, not the best one for you.
We posit that with solid guidance, you can avoid taking that sort of risk even if you spend, as you should, most of your time and energy on your grades as a 1L.
And we’re here to provide you with that guidance. This week we were focused on private equity, but there are other areas that represent interesting and lucrative lines of business for Biglaw that you might want to consider. Stay tuned.
We hope you enjoyed this week’s issue. We welcome any and all feedback, questions or concerns. You can send them to jack@top1l.com.