Private Equity Explained: What It Is, Different Strategies, and How These Investors Make Money

Private equity is money invested into companies or opportunities that are not available to the general public. Private equity is a broad term that covers real estate, equity, and debt investments; private equity investing is the most lucrative form of finance, given the types of returns investors can expect.


In this article, we’ll break down everything you need to know about private equity investing.


To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.

Table of Contents

What is private equity in simple terms?

Private equity (PE) firms manage investment partnerships that acquire and oversee companies before selling them. These funds may purchase private or public companies entirely or invest in buyouts as part of a group. Typically, private equity firms do not hold stakes in publicly listed companies.


Private equity is categorized as an alternative investment alongside venture capital and hedge funds. Investors must commit significant capital for several years, limiting access to institutions and high-net-worth individuals. Unlike venture capital, PE firms and funds focus on established companies rather than startups, managing their portfolio companies to increase their value before selling them years later. Private equity has grown rapidly in recent years, driven by increased allocations to alternative investments and strong returns since 2000.


Private equity investing is most lucrative during times of high stock market growth and low-interest rates. PE firms raise client capital to create private equity funds, which they manage as general partners, receiving fees and a share of profits. These funds have a finite term of 7 to 10 years, and the capital invested in them is not available for subsequent withdrawals. After a few years, the funds begin to distribute profits to their investors.


What are the different types of private equity?

Private equity investments aim to generate profits for investors, typically within 4-7 years, which is a faster turnaround time compared to traditional investing.


Currently, the global PE fund market has $2.5 trillion in assets. While PE is an alternative form of funding that is not public and not subject to market conditions, there are several distinct types of private equity funds, including venture capital, growth equity, fund of funds, and distressed private equity.


Let’s explore each in detail.


Venture capital


Private equity investors that want to focus on investments with long-term growth potential often turn to venture capital funds or VC investments. Venture capital funds are typically operated with a managing partner and other operating partners/passive partners. The VC fund consists of pooled investments in high-growth opportunities in startups and early-stage companies. Venture capital funds are usually only available to accredited investors.


VC funding is provided to startups or entrepreneurs directly. Investment can be made at any stage of the business, whether it’s a startup, scale-up, or in its growth stage. Some of the biggest companies that have leveraged VC funding as part of various investment rounds over time include AirBnB and Slack. Slack eventually went public and was bought by Salesforce; AirBnB raised $6 billion in funding across 33 investment rounds.


This form of PE has several pros and cons. Venture capital firms typically consist of affluent and well-connected ex-startup professionals who possess the business knowledge and connections necessary to secure significant amounts of funding. One of the primary benefits of securing a VC investment is gaining access to substantial capital.


Furthermore, VCs typically offer valuable networking opportunities and leadership experiences. Whether it’s through operating assistance, the partner’s experience, or connections to industry experts, there are numerous chances to learn and network with your VC investors that can aid in the growth of your business.


Unlike traditional loans, VC investments do not require monthly payments or recurring fees. VCs are looking for long-term returns, which means their expected gains are repaid by the success of your business. This open-ended return plan allows the founding team to avoid worrying about any costs associated with taking on VC funds.


Taking on a venture capital fund as an investor provides the possibility of future large investments from the same VC or other influential VCs. VCs often provide additional assistance with public relations, hiring, risk management, and more, creating opportunities for further growth and success.


However, there are a few downsides to this approach as well. In return for providing large sums of money (without a recurring repayment schedule), the VC will likely ask for a significant ownership stake in the company they invest in order to double or triple their returns. This can easily lead to the dilution of the company and significant losses for the founding team.


The entire process of raising capital through VCs can be very time-consuming and costly, which can distract from the growth of the business. If, at the end of the day, it isn’t growing according to the VC’s expectations, companies that have given up their majority stake stand to lose everything – which adds risk and pressure to the business.


Read more: What Is Venture Capital, How It’s Used, and How It Works


Growth equity

Growth equity is a type of private equity fund that invests in late-stage companies with established business models and high growth potential, making it a lower-risk investment option.


Growth equity deals are typically minority investments focused on quicker capital gains rather than long-term ownership opportunities. Companies like Spotify and Uber have used growth equity to scale their businesses and expand into new markets.


The pros of growth equity include maintaining control and having the opportunity for quick growth, while the main con is that there is typically no added value beyond cash to the business. Growth equity funds usually make non-majority stake investments, which allows for the infusion of cash without giving up ownership, but they do not offer the same value-added benefits as VC firms, like networking or advisory services.


Read more: Growth Equity 101: What it Is, Criteria for Growth Equity Investments, Plus How These Investors Add Value


Fund of funds

A fund of funds or multi-manager investment fund is a PE fund that invests in other funds, including hedge funds or mutual funds. Individuals can invest in a fund of funds to invest in several assets with lower capital requirements. A fund of funds is seen as a lower risk because there are lots of different investments that balance one another out during peaks and troughs in the markets.


Read more: Fund of Funds in Venture Capital: Three Valuable Benefits and What You Need to Know


Real estate private equity

Private equity real estate involves investing in professionally managed pooled private and public investments in real estate markets through an investment fund. It allows high-net-worth individuals and institutions to invest in equity and debt holdings related to real estate assets using an active management strategy that takes a diversified approach to property ownership. Private equity real estate investments are commonly pooled and can be structured as limited partnerships, limited liability companies, or other legal structures.


However, investing in PE real estate requires a long-term outlook and a significant upfront capital commitment with little flexibility and liquidity offered to investors.


It is a long-term investment that requires significant upfront capital commitments, and lock-up periods can last for more than a dozen years. Distributions can be slow, and investors have little flexibility and liquidity.


Private equity real estate investors include institutions, accredited private investors, and high-net-worth individuals. Although it is risky, private equity real estate can provide high potential levels of income with strong price appreciation. Returns for value-added or opportunistic strategies can be considerably higher, but investors can lose their entire investment if a fund underperforms.


Mezzanine capital

Mezzanine capital blends private equity and debt financing. If a company makes use of mezzanine capital, they are, in essence, taking a loan from the investor and giving away some capital in exchange. The investor can decide to convert the debt owed by the seeker of the investment to an equity interest in their company, usually when there is a default.


Later-stage companies often choose mezannine capital to acquire cash for short-term growth projects. The risk level is considered moderate for investors as they can recover their funding on a timely payback schedule. The return on investment is usually more positive, even in the event of a default, as the investor will receive more long-term gains. However, dips in valuation or future failures might render the equity invested worthless.


Distressed private equity

Distressed private equity is a type of investment where firms invest in failing or in-troubled companies’ debt or equity to gain control, make changes and turn the company around for profit. The potential for ROI is high, but the right strategy and operators are critical to success.


Distressed private equity means that there is the potential for realizing little to no ROI if the right strategy isn’t implemented. The time invested by the operating team can cut into the ROI and make the time feel more intense compared to passive PE investments.



What does a private equity fund do?

Private equity firms raise money from institutional investors, including insurance companies, pension funds, sovereign wealth funds, and family offices, in order to invest in private businesses. They then grow these companies before selling them later, generating far better returns for their investors than they would from public markets.


A private equity fund acquires ownership stakes in privately held businesses that are not listed on the public stock market, which involves a higher degree of risk than investing in public companies. They may use a combination of debt and equity financing to grow these businesses in close cooperation with the management team.


The PE fund managers will help the company improve operations, increase efficiencies and drive growth. Ultimately, the goal of private equity firms is to generate returns for investors, usually through an IPO (initial public offering) or a sale to another company or PE firm.

How does a private equity fund make money?

Private equity funds make their money through fees. These fees may vary between funds. Management fees are based on a percentage of the assets under management (AUM) and are usually around 2%. The management fee covers daily expenses and overheads. Performance fees are calculated as a percentage of the profits that have been made from investing, usually around 20%.


When PE firms acquire a company, they typically have a plan in place to increase the value, either through cost-cutting or restructuring measures that may have been previously avoided by the company’s incumbent management. Private equity owners have limited time to add value before exiting the investment, so they have a strong incentive to make major changes.


Many PE firms have specialized expertise that the previous management lacked and may assist the company in developing along those lines, e.g., adopting an e-commerce strategy, adopting new technology, or entering new markets. The private equity firm may bring in its own management team to pursue these initiatives or retain prior managers to execute an agreed-upon plan.


One advantage of ownership by a PE firm is that the acquired company can make operational and financial changes without the pressure of meeting analysts‘ earnings estimates or satisfying public shareholders every quarter. This allows the management to take a longer-term view unless it conflicts with the new owners’ goal of making the biggest possible return on investment.


It is worth noting that private equity firms do not operate without challenges. They are often criticized for their ruthless cost-cutting measures, which can result in job losses and diminished services. Additionally, PE firms typically invest with the aim of maximizing returns within a limited time frame, which may not align with the long-term interests of the company or its stakeholders.


Despite these challenges, PE remains a popular way for companies to raise capital and grow their businesses. Private equity firms often provide access to much-needed capital and resources, which can help companies achieve their goals more quickly than they would have otherwise. The specialized knowledge and expertise that private equity firms bring to the table can also be a major asset to companies looking to expand or make strategic changes.


What types of returns do private equity funds expect?

Private equity has generated impressive risk-adjusted returns over the long-term period of 2000 to 2021, according to a study of 94 state pension systems. The research found that the annualized net-of-fee return from PE was 11%, outperforming the 6.9% annualized return from public stocks.


The higher private equity returns did not come with higher risk. Over a 21-year period ending June 30, 2021, PE produced almost twice the investment gains over a 10-year period compared to public equity. The study found no evidence of convergence, with PE returns continuing to deliver the excess returns over public stocks compared to years past.


According to the U.S. Private Equity Index provided by Cambridge Associates, private equity produced average annual returns of 10.48% between June 2000 and June 2020. The Russell 2000 Index, which tracks the performance of small companies, averaged 6.69% per year during the same period, while the S&P 500 returned just 5.91%. The Venture Capital Index averaged 5.06% in the same period.


Based on these numbers, it’s clear that investors that placed a bet on private equity received higher returns than those who followed a more conventional investment route. It’s important to note that this is not always the case. Venture capital was the top performer between 2010 and 2020, with average annual returns of 15.15%, while S&P 500 returned 13.99% during this period, compared to a PE return of 13.77%.


What types of companies do private equity funds invest in?

Private equity funds may follow different strategies when it comes to choosing the companies they invest in, but they are almost always companies that have the potential for high growth. They’ll also look at businesses with strong cash flow and significant upside potential. Companies that fit the bill are often in the middle market or large-cap space, with enterprise values ranging from several hundred million to several billion dollars.


PE firms may have a specific focus or expertise and will exclusively target companies in those industries, such as healthcare, industrials, energy, or technology; others target multiple strategies.


Generally speaking, private equity firms look for companies that have a strong competitive position in their market and a skilled management team that poses opportunities for operational improvement and growth. These companies may already be well-established and profitable or might be startups with lucrative growth potential.


Where do private equity funds get their money?

Private equity funds may get their money from sources like:


  • Limited Partners (LPs): The majority of the capital comes from institutional investors, including pension funds, endowments, and insurance companies, as well as wealthy individuals.
  • General Partners (GPs): The partner who manages the private equity fund may also invest capital from their personal funds and receive a percentage of the profits as compensation.
  • Debt Financing: Private equity firms may also raise money through borrowing from banks or issuing bonds.
  • Co-Investment: Some private equity firms partner with other investors, such as family offices or strategic investors, to make a specific investment.


What are some examples of private equity funds?

There are several popular private equity funds, including:


The Blackstone Group


The Blackstone Group is a leading investment firm with a diverse portfolio of investments in private equity, real estate, hedge funds, credit, and infrastructure. Founded in 1985, Blackstone is headquartered in New York City and manages over $500 billion in assets. The firm’s portfolio companies include Service King, a leading collision repair provider in the U.S.; Optiv, a cybersecurity solutions provider; and Change Healthcare, a healthcare technology and services company.


TPG Capital


TPG Capital is a global private equity firm that was founded in 1992 and is based in San Francisco. TPG invests in a wide range of industries, including healthcare, technology, and consumer products. Some of its current portfolio companies include Greencross, a leading pet care provider in Australia; Reading International, a movie theater and real estate company; and Wind River Systems, a software company that specializes in embedded systems and IoT devices.


The Carlyle Group


The Carlyle Group is a global alternative asset management firm that specializes in private equity, real estate, credit, and infrastructure investments. Founded in 1987 and headquartered in Washington, DC, Carlyle manages over $260 billion in assets. The firm’s current portfolio companies include Memsource, a cloud-based translation management system; X-chem, a drug discovery company; and Vault Health, a telemedicine company.


HarbourVest Partners


HarbourVest Partners is a private equity firm that focuses on secondary and primary investments in venture capital, buyout, and mezzanine funds. The firm was founded in 1982 and is headquartered in Boston. Its current portfolio companies include Flash Networks, a mobile optimization company; Fundbox, a financial technology company that provides working capital to small businesses; and Rodenstock, a leading manufacturer of eyewear.


How is private equity different than venture capital?

Private equity (PE) refers to investments or ownership in private companies. It involves using capital committed by Limited Partners (LPs) to invest in mature businesses in traditional industries. Private equity firms typically take a majority stake in the companies they invest in, which means they own over 50% of the company. When a PE firm sells one of its portfolio companies, returns are distributed to the investors and LPs. Investors typically receive 20% of the returns, while LPs get 80%.


Venture capital (VC) is a form of private equity investment that focuses more on early-stage startups, particularly tech-focused companies. VC firms use committed capital to invest in young companies, usually taking a minority stake in the company, which means they own less than 50%. VC investments can be risky since most of these companies are not fully established or profitable, but they offer the opportunity for big returns. VC firms typically make a profit if a company they’ve invested in goes public, gets acquired, or by selling some of its shares to another investor on the secondary market.


In other words, private equity and venture capital differ in their investment focus and the type of companies they invest in. Private equity firms invest in mature companies in traditional industries, while venture capital firms focus on early-stage tech-focused startups. Additionally, private equity firms typically take a majority stake in the companies they invest in, while VC firms take a minority stake. Private equity investments are less risky and offer more stable returns, while venture capital investments offer the potential for higher returns but are riskier.


Private equity and venture capital firms get their money from various sources, including limited partners, general partners, debt financing, co-investments, and other sources such as government or corporate pension plans, sovereign wealth funds, and foundations. Limited partners are the primary source of capital for both private equity and venture capital firms, providing most of the money invested.


How is private equity different than growth equity?

The term “private equity” has become a catch-all term that has been applied to different private investment firms, including growth equity firms. This has led to confusion over the relationship between growth equity and private equity. Many private equity firms have even launched dedicated growth funds to compete within the growth investment stage.


Private equity and growth equity are both investment strategies that involve large amounts of capital and similar return expectations of around 25% IRR or more. However, they differ in their investment stages, transaction structures, and operational involvement. Private equity firms tend to invest in more mature companies that have stable profitability and cash flow, while growth equity firms invest in companies in the growth stage that may have low or negative overall profits due to investing in growth.


Growth equity investments are typically minority stakes, while private equity LBO buyout transactions involve a majority controlling stake and require large amounts of debt financing.


Private equity firms often have total control over governance and management, while growth equity firms influence companies’ operations through board seats or unofficial channels. Private equity firms generate returns primarily from debt reduction, while growth equity firms generate returns primarily from revenue or profit increases resulting in a larger equity valuation at the time of sale.


What is the history of private equity?

Private equity investments as we know them today began to emerge after World War II with the founding of the first two venture capital firms in 1946: American Research and Development Corporation (ARDC) and J.H. Whitney & Company.


ARDC, founded by Georges Doriot, was the first institutional private equity investment firm that raised capital from sources other than wealthy families. Georges Doriot is widely considered as being the “father of private equity.”


ARDC had several notable investment successes, including a 500 times return on their investment in Digital Equipment Corporation. Former employees of ARDC went on to find several prominent venture capital firms. J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt and continues to make investments in leveraged buyout transactions.


Before World War II, venture capital investments were primarily the domain of wealthy individuals and families. The Small Business Investment Act of 1958 allowed the U.S. Small Business Administration (SBA) to license private “Small Business Investment Companies” (SBICs) to help finance and manage small entrepreneurial businesses in the United States. The success of the SBA’s efforts is viewed primarily in terms of the pool of professional private equity investors that the program developed, as the rigid regulatory limitations minimized the role of SBICs.


What is the traditional background of somebody that works in private equity?

Most entry-level associates in the private equity field have a minimum of two years of banking industry experience or a bachelor’s degree in finance, accounting, economics, or related fields. Due to a limited number of job opportunities and high competition, breaking into private equity is challenging. It is almost impossible to start a career in private equity without prior experience, making internships or previous experience in a related field essential.


Bottom line

Private equity (PE) firms have grown to manage trillions of dollars, drawing the attention of wealthy individuals and institutions as investment opportunities.


To enter this asset class, it is important to understand what private equity is and how it creates value. The industry attracts top talent, and its professionals are adept at deploying investment capital and increasing portfolio company values. However, competition for good companies to buy is intense, so developing strong relationships with transaction and service professionals is crucial for securing a solid deal flow.

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