Underpaid Private Equity Professionals?

December 24, 2012

Contrary to what appears to be popular opinion, almost everyone that thinks in terms of value added comes to the same conclusion that professional athletes are generally underpaid, and usually by a good amount.  An opposite conclusion holds true for the earnings of doctors, whose wages and output generally fall in the category of overcompensation (although there are certainly cases where individuals would give everything they own for the help of a physician).

What about private equity professionals – are they paid around what they’re worth?  The answer lies in how much weight one gives to such things as government regulation, union, risk, and many other market and non-market factors.

For instance, pilots at major airlines can earn between $140K and $220K, a good amount more than pilots at small regional carriers or pilots flying commuter lines ($25K to $100K).  What’s behind the differential?  Well, in this case it’s unions.  Absent the presence of unions, the market clearing wage for a major airline pilot would probably be somewhere around $50K.

What about doctors? What explains their above-market clearing wages?  The answer lies with a few factors.  First, the industry and the group as a whole is highly regulated, with government regulations limiting competition on who may perform certain procedures and industry representatives doing their best to control the supply of practicing physicians (lower supply generally pushes prices up).  These regulations account for a good portion of doctors’ high salaries.  Other things, such as hidden prices and uninformed consumers also affect physician compensation.  Interestingly, even after accounting for government regulation, industry supply self-regulation, hidden prices, and uniformed consumers, there are still other unknown reasons as to why doctors are able to pull off higher than expected compensation.  The unknown reasons probably take the form of non-quantified fear of dying and social respect.

What’s the big reason private equity professionals are generally worth more than pretty much all other professions, including the medical and legal professions?  The answer not only lies in their business skills, but in their risk tolerance.  Overall, in professionals with high degrees of risk, pay is generally higher.  When it comes to private equity, there’s a large amount of risk, at as measured in terms of the thousands, millions, and billions of dollars put on the line very day.  Not surprisingly, a like component of risk exists in many of the competing financial professions, such as hedge fund manager as compared to a low risk bond manger, with the highest paid usually possessing (again, just as a general rule) a higher amount of risk.

This background doesn’t address the question as to whether the current pay structure of private equity professionals understates their actual value to society.  Well, that depends on, among other things, how much value individuals place on the value of wealth creation, the reward individuals should receive for taking on risk, and regulations placed on the industry.  As an initial look that will be addressed in a separate post, it certainly looks as though industry professionals are compensated much less than what they’re worth, at least when it comes to comparisons with such professions as medical or legal professions.  More figures are to come.

In all, if you’re looking at making a good deal of money, move beyond the low risk portions of the medical and legal professions into the high risk sections of the financial industry.  If you’re good, world class compensation will most likely follow.

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