“You must show that you know how to think like an investor”
Buyside headhunters will tell you to “think like an investor” for private equity and hedge fund interviews. Does anyone even know what that means? How is it even different from thinking like an investment banker? In both roles, you’re building models to see if the returns are attractive for an investment. So how’s it different and how do you show that you can “think like an investor” during a PE/HF interview?
It’s true that in both roles, you’re building a model to determine the returns for a particular investment. But there are 2 complexities here that investment professionals spend significant time on that bankers don’t. These are the two qualities you need to convey:
- In order to arrive at the returns profile, you need to be able to intelligently project out the financials. And unlike banking, where you just take management forecast or equity research numbers, as an investor, you actually have to come up with your own projections. And in order to come with intelligent projections, you have to be able to understand the business model.
- In banking, you’re mostly concerned with whether the IRR is above a certain threshold so that the VP / MD can show their client that the deal makes sense. As an investor, you actually need to think about whether the returns are attractive enough given the risks you will have to bear in order to achieve that return. This means you need to think about the risk / reward dynamics.
Understanding the Business Model
The first step to think like an investor is to understand the business model.
When investment bankers build their financial models, the industry standard for the projections is to pull them from a research report close to street consensus or management-provided forecast. Barely any thought is put into these numbers by the bankers and they’re not supposed to.
As an investor, the mindset needs to change. It’s now your responsibility to form a view on each line item in the financial projections. That’s what the job is. Your team expects you to have a solid reasoning on why you’re projecting revenue growth of 10% instead of 5% and why margins are expanding. And the answer can’t be “IBES consensus”. Investors project their financials based on drivers of revenue and cost (i.e. price vs. volume for different product lines, new customer wins vs. renewals, employee headcount vs. compensation changes, etc) and what they’ve found through due diligence (i.e. customer surveys show that they’re willing to tolerate a 5% price increase before going to a competitor so you modeled an annual 5% price increase). And in order to do that, you need to have a good grasp of the business model.
What this means for your interview preparation is that you need to spend time to fully understand the business model of the company involved in the deal that you put on your resume AND be able to quickly grasp this for a new company that the interviewer might put in front of you. How does the company generate revenue? What’s the price / volume, product, geography, customer mix like? What are the costs associated with the revenue and how do they change in relation to incremental revenue?
Get this down and you’re half way there!
Evaluating the Risk / Reward Dynamics
Okay, so now you know that you need to be able to understand a business in order to make intelligent financial projections. But no projections are perfect and unforeseen events happen all the time. There could be a product recall which kills the consumer brand image, a research finding that changes consumer behavior, a new technology that disrupts the industry, competition can intensify, etc. You get the point. As an investor, you actually have to think about the risks associated with the projections that you’re making.
Private equity associates and hedge fund analysts spend a lot of time assessing the risks. And the idea here is to determine 1) what the key risks are, 2) their impact on the projections, 3) their mitigants, 4) their likelihood and 5) whether the returns are attractive enough to justify these risks. In banking, you’re instructed that returns need to be above the 20% threshold. As an investor, you have to think about whether the 20% return is worth the risk. An 18% IRR from an extremely stable and sticky business has a much better risk / reward profile than a 20% IRR from a cyclical and declining business where all stars had to align.
In practice, the buyside investors will develop a downside scenario where they show the key risks playing out and how that will affect the returns. Then, that downside return (or loss) scenario is compared to the base case. Sophisticated investors look for investment opportunities where there are outsized base case returns vs. downside loss.
Risk / Reward Dynamics Example
Consider hedge funds’ thesis on IAC Interactive back in 2014 / 2015. IAC Interactive was a large media company that had a number of assets such as Match.com, Vimeo, CollegeHumor, Tinder, etc. The idea was that the just the assets excluding Tinder is worth the market stock price. In other words, the market didn’t price in the value of Tinder and so the investors are basically getting Tinder for free. If the stock market increases its valuation for Tinder, then the stock will rise tremendously. But even if Tinder completely shuts down and the market never recognizes any value for it, the stock price is fairly valued and investors probably won’t lose any money even if their thesis doesn’t work out. Said differently, the hedge funds played a coin toss game where heads they win, tails they don’t lose.
Now that’s a very powerful risk / reward dynamic. Find a couple of these and you’ll be very successful.
Summing It Up
When the recruiters and interviewers say that candidates need to “think like an investor”, they mean that you need to show that you 1) understand business models and 2) think about risk / reward dynamics. This will be demonstrated in interviews via technical questions, deal experience discussion, stock pitch, and case studies.
Have follow up questions? Leave us a comment and we’ll get back to you.
About 10X EBITDA
We are a small team composed of former investment banking professionals from Goldman Sachs and investment professionals from the world’s top private equity firms and hedge funds, such as KKR, TPG, Carlyle, Warburg, D.E. Shaw, Citadel, etc. Our mission is to cultivate the next generation of top talent for Wall Street and to help candidates bring their careers to new heights. We’re based in the United States, but we have expertise across Europe and Asia as well.