What Is Private Equity? How It Works and Ways to Invest

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Private equity is capital invested in companies that do not trade on a public stock exchange. It also includes deals that take listed companies private. A private equity firm raises money from investors into a fund, uses that money (usually alongside borrowed money) to buy stakes in businesses, works to make those businesses more valuable, and sells them years later. Profits from the sale are split between the fund’s investors and the firm. This kind of investing ties up large sums for long periods, and access to traditional funds has largely been limited to institutions and wealthy individuals.

What Is Private Equity?

The term can refer to the asset class, the funds that invest in it, or the firms that manage those funds. A company described as “private equity owned” has a private equity fund, or a group of funds, holding a controlling or significant stake in it.

Most private equity firms invest in mature companies rather than startups. The target is typically an established business with revenue and cash flow that the buyer believes is underperforming, undervalued or ready to grow. Funds may buy a company outright or join a consortium of buyers for larger deals. Traditional funds generally do not keep stakes in companies that remain listed, which separates private equity from investors who buy shares on the open market.

Private equity is usually grouped with venture capital and hedge funds as an alternative investment, meaning something outside the conventional mix of publicly traded stocks, bonds and cash. Their strategies, holding periods and investors differ substantially, as covered below.

A traditional fund asks investors to pledge capital for roughly 10 to 12 years, and the money comes back only as the fund sells its holdings. In exchange for accepting that lock-up and the higher fees, investors hope to earn returns above what public markets deliver.

How a Private Equity Fund Works

A private equity firm is the management company. A private equity fund is the investment vehicle the firm creates and runs. A single firm typically runs several funds at once, often raised in different years and focused on different strategies. Most funds are organized as limited partnerships, and that structure explains most of how the money moves.

General partners and limited partners

The general partner (GP) is the private equity firm, or an entity it controls. The GP finds deals, decides what to buy and sell, oversees the portfolio companies, and handles the fund’s administration. Investors can hold certain consent or advisory rights. The GP usually puts some of its own money into the fund so it has a direct stake in the outcome, though the amount varies.

The limited partners (LPs) supply most of the capital. They include public and corporate pension plans, university endowments, foundations, insurance companies, sovereign wealth funds, family offices and wealthy individuals. Their liability is generally limited to what they have committed, and they do not run the fund’s day-to-day affairs.

Commitments, capital calls and the fund life

Investors do not hand over their full pledge on day one. They sign a capital commitment, and the GP draws on it through capital calls as it finds deals. The early years of a fund are the investment period, when the GP buys companies. The later years are spent improving and selling them. Proceeds from each sale are distributed to investors along the way, and the fund winds down once the last holdings are sold.

Because fees are charged and deals are made before any company is sold, a fund’s reported returns often look weak in its first years and improve as exits arrive. Between sales, investors see the fund’s estimated net asset value (NAV), which is the GP’s valuation of holdings that have no market price. Those estimates are not the same as cash returned.

How the firm gets paid: 2 and 20

The GP earns money in two ways:

• Management fee: traditionally about 2% a year, charged on fund assets or committed capital depending on the fund’s terms. It pays for salaries, deal sourcing and operations whether or not the fund performs.
• Carried interest: the GP’s share of profits, traditionally 20%, paid only after investors have received their capital back plus a preset minimum return, the hurdle rate.

The order in which cash flows to each party is called the distribution waterfall, and its details (whether the GP gets a catch-up after the hurdle, and whether carry is calculated deal by deal or across the whole fund) change how much each side receives.

Hypothetical fee example. Assume LPs contribute $100 million to a fund. Over its life the fund returns $180 million to investors before carry, a profit of $80 million. For simplicity, assume the profit clears the hurdle and the GP receives a full 20% of all profits. Carried interest is then $16 million, and LPs keep $64 million of the profit. Management fees of 2% a year on $100 million would also have cost about $2 million annually while they applied, which is why an LP’s net return on investment can be well below the gross return on the fund’s deals.

Specialties and Types of Private Equity Deals

Private equity firms often specialize by strategy, industry or deal type. The main categories are these.

Leveraged buyouts (LBOs). The classic private equity deal. The fund acquires a controlling stake in a company (public, closely held or privately owned) and finances a large share of the price with debt that sits on the acquired company’s balance sheet. When the target is an underperforming public company, the new owners often cut costs and restructure operations.

Carve-outs. The fund buys a division or subsidiary from a larger company, often a unit the parent considers non-core. Carlyle’s 2014 purchase of Tyco’s Korean fire and security business, and Francisco Partners’ deal to buy the Litmos training platform from SAP, announced in 2022, are examples. Carve-outs tend to be priced at lower valuation multiples than other buyouts, but separating a business from its parent’s systems, staff and contracts makes them more complex and riskier.

Secondary buyouts. One private equity firm sells a portfolio company to another. These deals have become more common as firms specialize. One firm might buy a business to fix its costs, then sell it to another that wants a platform for acquiring complementary companies.

Growth equity. Minority or majority investments in companies that are past the startup phase and need capital to expand, often without heavy debt.

Distressed investing. Investments in struggling companies with urgent financing needs, sometimes through their debt, with the goal of restructuring and recovery.

Sector specialists. Some firms invest only in one area, such as technology, health care or energy, and build operating expertise around it.

How Private Equity Firms Create Value

A buyout firm usually arrives with a plan to raise the company’s value before it closes the deal. The plan can involve several levers.

Operational changes. Cost cuts, restructuring, new pricing, consolidation of suppliers, technology upgrades or expansion into new markets. An owner with a limited window to add value has a strong incentive to make major changes quickly, including ones incumbent management avoided.

Management. The firm may install its own executives or keep existing managers and tie their pay to an agreed plan, often through equity stakes that pay off only if the company is sold at a higher value.

Add-on acquisitions. A fund may use one company as a platform and buy smaller competitors, combining them to gain scale.

Freedom from quarterly reporting. A private company does not need to meet analysts’ earnings estimates each quarter. That can let management take a longer view, unless the long view conflicts with the owners’ timetable for selling.

Industry surveys indicate that operational improvement has become the main source of value that private equity managers point to. Debt still plays a large role in returns, even though firms rely on it less than in earlier decades.

Earning returns through leverage

Borrowing reduces the equity a fund needs to put into a deal. If the company’s value rises, the gain is spread over a smaller equity base, so the percentage return on equity is higher. If the value falls, the loss is concentrated on that same smaller base.

Hypothetical leverage example. A fund buys a company for $100 million. Consider two financing choices, and assume for simplicity that interest is paid from the company’s cash flow and the debt balance is unchanged at exit.

The same change in company value produces a much larger swing in the equity return when debt is used. In real deals, interest costs reduce cash flow, debt paydown over the holding period adds to equity value, and lenders impose covenants. If the company cannot service its debt, it can go bankrupt and the equity can be wiped out entirely. A fund spreads risk across several companies, so one failure does not necessarily sink the whole fund, though fund-level losses are still possible.

A dividend recapitalization pushes this further. The portfolio company borrows money and uses it to pay a dividend to its private equity owners. The fund gets cash back early without selling, and the company is left carrying more debt. The practice is controversial because it shifts risk onto the business, its employees and its lenders.

How Private Equity Firms Exit Their Investments

Exiting is how a fund turns paper gains into cash for its investors. The main buyers of private equity owned companies are:

• Strategic buyers: competitors or other companies in the same industry that want the business for its products, customers or market share.
• Other private equity firms: the secondary buyout described above.
• Public investors through an IPO: the company lists its shares on an exchange, and the fund sells its stake over time.
• Continuation funds: the GP moves one or more assets from an existing fund into a new vehicle it also manages, giving existing LPs the option to cash out or roll over. Critics question whether the price is fair when the same sponsor sits on both sides of the sale.

When sales slow, holding periods lengthen and cash returns to investors are delayed. Delayed distributions also affect fundraising, since LPs often rely on money coming back from older funds to commit to new ones.

How to Invest in Private Equity

Traditional private equity funds. These remain mainly the domain of institutions and very wealthy individuals. Offerings are typically limited to accredited investors or other qualifying categories. Under the SEC’s standard, an individual is accredited with net worth over $1 million excluding the primary residence, or income above $200,000 ($300,000 jointly with a spouse) in each of the past two years with the expectation of the same in the current year. Many funds set minimum commitments in the millions of dollars and lock capital up for roughly 10 to 12 years.

Feeder funds and registered structures. Some vehicles pool money from many smaller investors and invest it in a larger private equity fund, or package private equity holdings in a registered fund with lower minimums. They widen access but add their own layer of fees and usually limit how often investors can withdraw.

Listed private equity firms. Shares of publicly traded managers such as Blackstone (BX), KKR (KKR), Apollo Global Management (APO) and Carlyle Group (CG) can be bought in an ordinary brokerage account. Owning the stock means owning part of the management business, which earns fees and carry. It is not the same as owning a share of the funds, and the stock’s performance does not track fund returns exactly.

Private equity ETFs. Funds such as the Invesco Global Listed Private Equity ETF (PSP) hold a basket of listed private equity companies, giving diversified and indirect exposure to the private businesses they own. Like any ETF, they trade during market hours, so they remove the illiquidity of a traditional fund while carrying the volatility of the stock market.

Private Equity vs. Related Terms

Private equity vs. venture capital. Both invest in private companies. Private equity buyout funds usually buy control of mature, cash-generating businesses and often use debt. Venture capital takes minority stakes in early-stage companies, rarely uses leverage and depends on a small number of large winners.

Private equity vs. hedge funds. Hedge funds mostly trade liquid securities such as public stocks, bonds and derivatives, and usually let investors withdraw periodically. Private equity funds own companies for years and return capital only as holdings are sold. Both commonly charge a management fee plus a performance fee.

Private equity vs. asset management. Asset management is the broader business of investing money on behalf of others, including mutual funds, ETFs, pension mandates and wealth management. A traditional asset manager typically buys minority positions in listed securities and does not run the companies. A private equity firm takes control and operates the business.

Private equity vs. public equity. Public equity is shares traded on exchanges, priced continuously and covered by disclosure rules for listed companies. Private equity holdings have no daily market price, so the manager estimates their value until a sale sets an actual price. Comparisons with indexes such as the S&P 500 depend heavily on how those estimates and the timing of cash flows are handled.

Limitations and Risks of Private Equity

Illiquidity. Selling an LP stake before the fund ends is possible only through the secondary market, often at a discount.

Capital call obligations. An LP must meet capital calls when they arrive, even in a market downturn. Investors who pledge more than they can fund on short notice face penalties under the fund’s terms.

Fees. Beyond the management fee and carried interest, portfolio companies may also pay transaction or monitoring fees to the firm, depending on the fund agreement.

Manager dispersion. Performance varies widely across firms and strategies. Whatever the asset class has delivered on average, an individual fund’s result depends heavily on which manager you choose, and LPs commit before knowing which companies the fund will buy.

Valuation lag. Interim NAVs move more smoothly than public market prices, which can make private equity appear less volatile than it is and can flatter risk-adjusted measures such as the Sharpe ratio.

Tax and reporting complexity. Partnership investments generate their own tax reporting and can create obligations in multiple jurisdictions.

Criticisms of Private Equity

Private equity firms reject the description of themselves as asset strippers, but criticism of the industry has grown, with health care drawing particular attention.

A 2025 bipartisan report by the Senate Budget Committee, led by Senators Sheldon Whitehouse and Chuck Grassley, found that private equity ownership of hospitals had detrimental effects on patient care in underserved communities. It said Leonard Green & Partners received $424 million in distributions and more than $13 million in fees from Prospect Medical Holdings, and linked the two companies’ decisions to hospital distress, closures and reduced access to care. The report also argued that rapid staff reductions and facility closures after acquisitions disrupt employees and communities in other sectors too.

Academic research has raised similar concerns. One study estimated that private equity ownership increased short-term mortality among Medicare nursing home patients by 11% compared with other ownership. A 2019 study of 484 public-to-private leveraged buyouts found a bankruptcy rate of about 20%, against about 2% for a matched group of comparable companies. In retail, private equity owners have been blamed for pushing a number of large chains into bankruptcy.

Supporters respond that private equity provides capital and management expertise to companies that might otherwise stagnate or fail, and that many portfolio companies grow and add jobs under private ownership. The debate over private equity’s overall economic effect continues.

The carried interest tax debate

In the U.S., qualifying carried interest can be taxed at long-term capital gains rates rather than ordinary income rates, generally when the underlying investment has been held for more than three years. Management fees are taxed as ordinary income. Critics argue that carry is compensation for managing other people’s money and should be taxed like wages. Despite repeated legislative attempts to change it, the treatment remains in effect.

Are Private Equity Firms Regulated?

Yes, though more lightly than mutual funds. In the U.S., private equity funds generally rely on exclusions from the definition of an investment company under the Investment Company Act of 1940, and they raise money through offerings exempt from registration under the Securities Act of 1933. That is why they are typically restricted to accredited and other qualifying investors.

The managers are still regulated. Private equity advisers are subject to applicable provisions of the Investment Advisers Act of 1940, and funds and managers are bound by the anti-fraud provisions of federal securities law.

The SEC proposed expanded rules for private fund advisers in February 2022 and adopted them in August 2023. They would have required quarterly statements covering fund performance, fees and expenses, along with annual fund audits. On June 5, 2024, the U.S. Court of Appeals for the Fifth Circuit vacated those rules, so the requirements did not take effect.

A Brief History of Private Equity

Buying a company, reorganizing it and profiting from the result predates the industry’s name. In 1901, J.P. Morgan bought Carnegie Steel for $480 million and combined it with Federal Steel, National Tube and other companies to form U.S. Steel. In 1919, Henry Ford used mostly borrowed money to buy out his partners after minority shareholders John and Horace Dodge sued him over halted special dividends, an early leveraged buyout. The industry’s defining moment came in 1989, when KKR acquired RJR Nabisco for $25 billion, a symbol of both the scale private equity could reach and the debt it could load onto a company. Large firms are now listed on stock exchanges and manage funds across buyouts, credit, real estate and infrastructure.

The Bottom Line

Private equity matters most to institutions and wealthy investors who can commit capital for roughly a decade and meet capital calls on demand. Returns depend heavily on the manager chosen, and fees, debt and estimated valuations can make results look better or worse than the cash investors finally receive. Individuals without accredited status can gain indirect exposure through listed private equity firms or ETFs, accepting stock market volatility in place of a long lock-up.