Private Equity: What It Is, How It Works, and How Returns Are Generated
Last updated 04/22/2026 by
Ante Mazalin
Edited by
Andrew Latham
Summary:
Private equity is a form of investment capital raised by firms that acquire ownership stakes in private (non-publicly-traded) companies, restructure or grow them over several years, and then sell them — typically at a profit — through a public offering, merger, or direct sale.
It encompasses several distinct investment strategies.
- Leveraged buyouts (LBOs): Best for acquiring established, cash-flow-positive companies using a mix of equity and significant debt financing.
- Venture capital: Best for early-stage companies with high growth potential — higher risk and longer timelines than traditional private equity.
- Growth equity: Best for mature startups that need capital to scale but aren’t yet ready for or interested in a full acquisition.
- Distressed investing: Best for firms that specialize in acquiring underperforming or financially troubled companies at a discount and turning them around.
Private equity has quietly shaped more of the economy than most people realize — from hospital chains and dental practices to restaurant franchises and software companies, PE-backed firms operate in nearly every industry.
Understanding how private equity works matters not just for investors, but for anyone who works for, borrows from, or receives services from a company that may be PE-owned.
How Private Equity Firms Make Money
PE firms raise money from institutional investors (pension funds, endowments, sovereign wealth funds) and wealthy individuals through closed-end funds with defined lifespans — typically 10 years.
They charge two types of fees:
- Management fee: Typically 2% of committed capital annually, paid regardless of performance — covering salaries, overhead, and deal costs
- Carried interest (carry): Typically 20% of profits above a hurdle rate (usually 8%) — the performance incentive that aligns fund managers with investor returns
The “2 and 20” structure has been criticized for creating incentive misalignments, particularly when management fees remain substantial even during periods of underperformance.
The Leveraged Buyout Model
The leveraged buyout is the most common private equity transaction. A PE firm acquires a company using a combination of equity (from the fund) and debt (borrowed against the target company’s assets or cash flows).
Leverage amplifies returns: if a PE firm buys a $500 million company with $100 million of equity and $400 million of debt, and sells it three years later for $700 million, the $200 million gain on $100 million of equity is a 100% return before accounting for debt repayment — not the 40% gain the raw price difference suggests.
The risk of leverage is equally amplified — a declining company carrying heavy debt can default, wipe out equity value, and leave behind layoffs and creditor losses. According to research by the National Bureau of Economic Research, PE-owned companies are significantly more likely to file for bankruptcy than comparable public companies with similar leverage levels.
How a Private Equity Investment Works (Start to Exit)
A typical PE investment moves through these phases over a 4-to-7-year hold period.
- Fundraising: The PE firm raises capital from limited partners (LPs) into a closed-end fund with a defined investment period and term.
- Deal sourcing and due diligence: The firm identifies acquisition targets, evaluates financials, management quality, market position, and growth levers.
- Acquisition: The firm structures the deal — typically using 40–60% equity and 40–60% debt — and takes a controlling ownership stake.
- Value creation: Over a 3-to-7-year hold period, the firm works to improve operations, cut costs, grow revenues, make add-on acquisitions, or restructure the business.
- Exit: The firm sells its stake through an IPO, sale to a strategic buyer (corporate acquisition), or secondary sale to another PE firm.
- Distribution: Returns are distributed to limited partners after management fees and carried interest.
Private Equity Returns vs. Public Markets
PE firms have historically claimed superior returns to public market benchmarks, but the comparison is contested.
| Metric | Private Equity (historical avg.) | S&P 500 (historical avg.) |
|---|---|---|
| Gross returns | ~13–15% IRR (top quartile funds) | ~10–11% annualized |
| Net returns (after fees) | ~9–12% | ~10–11% |
| Liquidity | Illiquid — 10-year lock-up | Fully liquid |
| Transparency | Limited — quarterly reports only | Real-time pricing |
| Minimum investment | $1M+ (institutional); $25K+ (retail access) | No minimum (via index funds) |
Pro Tip
The net-of-fees return comparison between private equity and public markets is closer than the industry typically presents. Cambridge Associates and other benchmarking firms have found that top-quartile PE funds outperform public markets over long periods, but median and bottom-quartile funds do not — and investors can’t know in advance which quartile a fund will achieve. Fee drag (2% management fee plus 20% carry) is substantial and must be factored into any comparison.
Who Can Invest in Private Equity
Traditional PE funds are open only to accredited investors and institutional investors — due to SEC rules designed to protect investors from illiquid, complex, high-risk products.
Retail access has expanded through several channels:
- Business development companies (BDCs): Publicly traded companies that invest in private businesses — accessible via brokerage account
- Interval funds: PE-focused mutual funds with limited (quarterly) liquidity windows
- Publicly traded PE firms: Companies like Blackstone, KKR, and Apollo allow stock ownership in the PE manager itself
- Your 401(k): Some employer plans now include private equity as an option following DOL guidance changes
Private Equity’s Impact on Workers and Industries
PE ownership tends to prioritize margin improvement and exit returns over long-term employment stability. Cost-cutting, headcount reduction, and outsourcing are common value-creation levers.
Research has produced mixed conclusions — some studies show PE-backed companies ultimately create more jobs; others show job losses concentrated in the first 1–2 years post-acquisition. The outcome depends heavily on the sector, deal structure, and fund strategy.
Key takeaways
- Private equity firms raise capital from institutional investors, acquire companies, improve them over 4–7 years, and sell for a profit.
- The leveraged buyout model uses debt to amplify equity returns — but also amplifies risk of bankruptcy and financial distress.
- PE firms typically charge a 2% annual management fee and 20% of profits (carried interest) above a hurdle rate.
- Net-of-fees PE returns are competitive with public market benchmarks only in top-quartile funds — and fund performance cannot be predicted in advance.
- Retail access has expanded through BDCs, interval funds, and publicly traded PE managers like Blackstone and KKR.
- PE-owned companies carry higher leverage and, per NBER research, a meaningfully higher probability of bankruptcy than comparable public peers.
Frequently Asked Questions
What’s the difference between private equity and venture capital?
Venture capital is a subset of private equity focused on early-stage companies — often pre-revenue or early-revenue startups. Traditional private equity focuses on established, cash-flow-positive businesses. VC takes smaller stakes across many bets; PE typically takes controlling stakes in fewer companies. Both raise capital in a similar fund structure with similar fee models.
How long is money locked up in a PE fund?
Typically 10 years, though the investment period (when new deals are made) is usually 5 years, followed by a harvest period when the firm exits positions and returns capital. Some funds allow limited secondary market transfers, but liquidity is fundamentally constrained compared to public equities.
Can private equity investments lose money?
Yes. Private equity is not a guaranteed return strategy. Funds can and do lose capital — particularly in distressed buyouts with high leverage, sectors that face structural decline, or macroeconomic downturns that compress exit multiples. The illiquid nature means losses can’t be cut quickly, and full realization of losses only becomes clear at the end of the fund life.
Is private equity the same as hedge funds?
No. Both are alternative asset classes with similar fee structures, but they differ significantly in strategy. Hedge funds typically invest in publicly traded securities and aim for returns in all market conditions; they offer more frequent liquidity (often quarterly). Private equity invests in private companies over longer horizons with capital locked up for years.
Interested in alternative investments? Compare options on SuperMoney’s investing reviews to evaluate platforms that provide access to non-traditional asset classes.
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