Private Equity Primer: Definition, Examples, Strategy, & Top Firms

The private equity industry is the source of much intrigue and mystery.

Many young professionals would kill to join the industry, due to its high pay, and yet many are confused about what it is and how it works.

That’s why I put together this brief primer. It’s exactly the walkthrough I wish I had when I started my career.

Below I cover private equity from all angles — the definition, the business model, the history of the industry, the various investment strategies, and all the top firms.

Let’s get started!

What Does Private Equity Do?

Private equity funds purchase companies to earn a return, usually via a leveraged buyout. This means that the private equity firm uses high amounts of debt to finance the purchase of the company (usually 50-70% of the total purchase price).

Usually, private equity funds purchase majority (or controlling) stakes in companies, so they can own and control them outright. In addition to earning returns from de-leveraging, private equity firms typically also seek to improve the companies they purchase through more efficient operations and cost cutting efforts.

After a certain period of time (usually ~5-7 years), the private equity firm will seek to sell their investment to capture the return. They measure their annual return using metrics like internal rate of return (IRR) or multiple on money (MoM).

Private Equity Fund Structure

Private equity funds invest capital on behalf of their “limited partners” (LPs). These LPs are typically foundations, non-profits, pension funds, or wealthy family offices.

The LPs commit capital to the private equity fund for a set period of time (usually 7-10 years), and they entrust the private equity firm’s investors (called “General Partners”) to deploy their capital into profitable investments.

Roles of LPs and GPs

In a typical private equity fund, LPs are the investors who provide the capital. They have limited liability, meaning their exposure to losses is restricted to the amount of capital they have committed to the fund. LPs do not engage in the day-to-day management of the fund but rely on the expertise of General Partners (GPs).

GPs are responsible for managing the private equity fund, making investment decisions, overseeing portfolio companies, and ultimately deciding when to exit investments. GPs are typically compensated through a combination of management fees and performance-based incentives known as carried interest, aligning their interests with those of the LPs.

Types of Private Equity Fund Structures

Private equity funds can be structured in various ways to suit the needs of both GPs and LPs. Below are some of the most common fund structures:

1. Closed-End Funds:
   • The traditional structure for private equity funds is the closed-end fund. Here, the fund has a fixed lifespan, usually around 10 years. During the first half of this period, the GPs focus on deploying capital, and in the latter half, they work on existing investments and returning capital to the LPs. These funds are illiquid, meaning LPs cannot access their capital until the fund starts to realize its investments.
2. Evergreen Funds:
   • Unlike closed-end funds, evergreen funds do not have a fixed termination date. These funds continuously raise and invest capital, allowing for ongoing investment opportunities. Profits from exits are reinvested into new opportunities, providing LPs with a more flexible and potentially more liquid investment option over time.
3. Fund of Funds:
   • A fund of funds (FoF) invests in a portfolio of other private equity funds rather than directly into companies. This structure offers LPs diversification across multiple funds, strategies, and geographies, which can reduce risk. However, it also introduces an additional layer of fees, as LPs are charged by both the FoF managers and the underlying funds.
4. Co-Investment Funds:
   • Co-investment funds allow LPs to participate directly in specific deals alongside the main private equity fund. These opportunities are often offered to existing LPs and come with the advantage of reduced fees, as they typically do not include additional management fees or carried interest.
5. Hedge Funds:
   • Hedge Funds are pooled investment vehicles that employ a wide range of strategies to generate returns. They typically invest in liquid, publicly traded assets, such as stocks, bonds, or derivatives. Hedge funds are designed for flexibility, allowing managers to adapt their strategies based on market conditions and capitalize on short-term movements.

If you’d like to go deeper, check out my deep dive on how private equity funds are structured, including entity structure.

Private Equity Loans and How They Work

Private equity firms use a mix of cash and borrowed money to fund their investments. These loans are a crucial part of how they operate and come in several forms.

• Mezzanine debt: Commonly used in company buyouts, it serves as a hybrid between traditional loans and ownership stakes. It offers lenders higher returns than regular loans, often between 12% and 20% per year (and can go up to 30% in certain cases). While it provides a more predictable return structure compared to equity, it helps bridge the gap when buyers don’t have enough cash for a purchase.
• Distressed debt: Some private equity firms specialize in buying loans of struggling companies at discount prices. The aim is to restructure these companies, make operational improvements, and potentially turn them around for a profit or get paid back on the discounted loans. This strategy involves significant risks, including the possibility of substantial losses if the company does not recover.
• Senior debt: Representing the most secure type of loan, this funding is typically provided by banks and backed by the company’s assets. If something goes wrong, senior debt holders get paid first before other lenders.
• Subordinated debt: This carries more risk since it is repaid only after senior debt obligations are met. While lenders can earn higher interest rates on these loans, they face the risk of being paid only after senior debt holders in case of company troubles.

These different types of loans are essential tools for private equity firms.

By using borrowed money alongside their own cash, they can buy larger companies than they could with just their own money. This strategy, known as leverage, allows them to potentially achieve higher returns on their investments.

For example, when buying a company, a private equity firm might combine their own money with mezzanine debt to complete the purchase.

Using debt this way lets them acquire larger businesses while putting up less of their own cash upfront. This strategy can lead to bigger profits when they eventually sell the company, assuming everything goes according to plan.

Private equity loans are fundamental to how these investment firms operate.

The various types of loans available give firms flexibility in how they structure their deals and pursue their investment goals.

Understanding Private Capital Regulations and Compliance

Private equity firms must navigate complex regulations designed to protect investors and maintain transparency. These rules shape how firms operate and interact with their investors.

The main regulations in the United States governing private investments come from the Securities Act of 1933 and the Securities Exchange Act of 1934.

• The Securities Act of 1933 requires firms to register their offerings with the SEC unless they qualify for specific exemptions, such as those under Regulation D.
• The Securities Exchange Act of 1934 primarily regulates transactions in the secondary market and does not directly govern the registration of private investment offerings.
• The Investment Company Act adds another layer of oversight for funds offering securities to the public. This requires SEC registration and following strict operational rules.
• Similarly, the Investment Advisers Act of 1940 governs how fund managers must behave, including their responsibilities to investors.

Preventing money laundering is also crucial.

Firms must screen potential investors and report any suspicious activities to authorities, involving thorough background checks and ongoing monitoring of transactions.

For international operations, additional regulations apply. For example, the European Union’s AIFMD sets specific requirements for alternative investment funds operating in Europe.

Key compliance challenges private equity firms face:

• Maintaining detailed records of financial statements, investor communications, and transactions.
• Extending due diligence timelines due to anti-money laundering checks and other regulatory requirements.
• Meeting the disclosure and operational rules of different regulatory frameworks across jurisdictions.

Achieving success in private equity requires a thorough understanding and careful adherence to these rules. 

Firms that maintain strong compliance practices build trust with investors and operate more effectively in today’s complex investment landscape.

Understanding Private Equity: The Key Players

Private equity can seem complex, but knowing who does what makes it easier to understand. Let’s look at the main players who make these investment funds work.

The General Partner (GP) is responsible for managing the fund. Think of them as the fund’s management team. They find investment opportunities, make the big decisions, and handle the day-to-day operations. 

General Partners are typically experienced professionals with expertise in finance and business strategy. The GP is legally responsible for managing the fund responsibly and acting in the best interest of the Limited Partners (LPs). 

A GP’s task includes ensuring the fund performs well and generates returns. However, their primary legal obligation is to act with fiduciary duty, not solely to ensure fund performance.

According to Investopedia, Limited Partners (LPs) are investors who provide the capital for the fund. These are typically big institutions like pension funds, university endowments, and insurance companies, along with wealthy individuals. 

While LPs don’t manage the fund directly, their role is crucial. They provide the capital that makes everything possible. In exchange, they get a share of any profits the fund makes.

A private equity fund structure typically reflects a limited partnership, managed by a general partner (GP), and funded by limited partners (LPs). The funds usually have a duration of 10 to 12 years, allowing for the management and exit of investments.

The relationship between GPs and LPs functions as a collaborative partnership. The GPs need the LPs’ money to make investments, while the LPs need the GPs’ expertise to make those investments successful. They spell out all the details in formal agreements, including how much the GPs get paid to manage the fund and how they’ll share the profits.

When everyone understands their role and responsibilities, the partnership works better for all involved. This clear understanding helps both the managers and investors work together effectively and achieve their financial goals.

How Does Private Equity Make Money?

Private equity funds make money by charging fees to their Limited Partners, on behalf of whom they are investing funds.

Private equity firms typically charge two kinds of fees:

• Management fees – this is a percentage fee (usually 2%) that is assessed on the total capital under management; these fees typically support the fund’s ongoing operations (e.g. office expenses, staff salaries, etc.)
• Carried interest fees – this fee is assessed as a percentage of the total profits earned on the investments the firm makes (usually 20%); typically, this fee is charged once the firm clears a certain threshold level of return. When performance is strong and the fund has had large returns on a big fund, these fees can be quite large (e.g. 20% of a $1 billion gain is $200 million)

Fee Structures and Economic Incentives in Private Equity

Building on the basic fee structure, it’s also important to understand how these fees align (or potentially conflict) with the interests of LPs and GPs.

Management Fees

As noted, management fees provide the necessary resources for private equity firms to operate. While essential for covering operational costs, the structure of these fees can sometimes create a misalignment with LPs’ interests. Since management fees are calculated based on the committed capital, GPs might be incentivized to raise larger funds even if that complicates efficient capital deployment. However, this risk is generally balanced by the performance-based nature of carried interest.

Carried Interest

Carried interest, or “carry,” is the primary performance-based incentive that aligns GPs’ financial interests with the success of the fund. Typically set at 20% of the profits, carry only becomes payable once the fund achieves returns above a predefined hurdle rate (often around 8%). This structure motivates GPs to maximize the performance of the fund to earn their share of the profits, aligning their goals with those of the LPs. Learn more about private equity carry.

Clawback Provisions

To further protect LPs, many private equity agreements include a “clawback” provision, which ensures that GPs return a portion of their carried interest if the fund’s overall performance doesn’t meet expectations by the end of its lifecycle. This provision is crucial for maintaining fairness, ensuring that GPs do not disproportionately benefit from early successes if the later performance of the fund underwhelms.

Fee Offsets

In some cases, private equity funds offer fee offsets, where part of the management fees is reduced by other income the GP earns, such as transaction fees or monitoring fees from portfolio companies. This helps align the cost structure more closely with LPs’ interests, ensuring that GPs do not unduly profit from charging both the fund and the portfolio companies for similar services.

Private Equity History

Private equity firms first rose to modern prominence during the 1980s during the period of so-called “corporate raiders.” During this period, private equity firms purchased several companies, including many public companies, and took them private.

There were several examples of deals that had high publicity, such as KKR’s acquisition of Nabisco (chronicled in the famous private equity book called Barbarians At The Gate).

However, the history of private equity actually goes back much farther. In fact, there are indications that the first “leveraged buyout” could be considered to have taken place as early as 1901 when JP Morgan purchased Carnegie Steel Corp for $480 million.

Private Equity Investment Strategies

While many associate private equity with “buyout” investing and specifically with “leveraged buyout” transactions, private equity can also generically refer to all private investing firms.

Using this broader definition, there are actually several types of investment strategies within private equity. Here are the main ones:

Leveraged Buyouts (LBOs)

LBOs involve acquiring a controlling interest in a company using significant amounts of borrowed capital. The firm’s objective is to enhance the company’s value through operational improvements, strategic growth, and cost efficiencies, eventually selling the company at a higher valuation. The high leverage amplifies potential returns but also increases risk, as the company must manage the debt load effectively.

• Risk: High financial leverage can lead to significant debt burdens, making the company vulnerable to financial distress if operational improvements or market conditions don’t materialize as expected.
• Reward: When successful, the equity returns can be substantial due to the use of leverage, amplifying the gains from relatively small initial investments.

Growth Equity

Growth equity involves investing in profitable companies that are poised for rapid expansion by taking minority stakes and providing capital to scale operations, enter new markets, or fund strategic acquisitions. This strategy targets companies with proven business models and revenue streams, offering a balanced risk profile with the potential for high returns from accelerated growth.

• Risk: Rapid scaling can introduce operational inefficiencies, market risks, and management challenges, potentially hindering the company’s growth trajectory.
• Reward: If the expansion is successful, the company’s valuation can increase significantly, providing substantial returns from capital invested during a critical growth phase.

Distressed Investing

Distressed investing targets companies that are financially troubled, often on the verge of or in bankruptcy. Firms purchase these companies at a discount with the intent to restructure operations, manage debt, and revitalize the business. Success heavily depends on the firm’s ability to turn around struggling companies, which may involve renegotiating debt, implementing new management strategies, or divesting non-core assets.

• Risk: High likelihood of failure if the distressed company cannot be successfully restructured or if external market conditions worsen, leading to potential losses.
• Reward: Acquiring companies at a deep discount allows for the potential of outsized returns if the firm can turn around the business and restore profitability.

Restructuring

Restructuring focuses on companies in financial distress, particularly those undergoing formal bankruptcy processes. Firms look for businesses with valuable core operations but burdened by excessive debt or mismanagement. By injecting fresh capital and implementing a new management approach, the goal is to stabilize the company, restructure its debt, and restore profitability.

• Risk: Involves complex negotiations and operational challenges, including legal issues and creditor conflicts, which can complicate the restructuring process and threaten its success.
• Reward: Successful restructuring can stabilize the company’s financial position, restore profitability, and generate significant value for investors.

Venture Capital

Venture capital focuses on investing in early-stage companies with high growth potential. These startups typically have unproven business models and lack a stable revenue stream, making them inherently riskier. However, they offer the potential for outsized returns if the company successfully scales and achieves market dominance.

• Risk: Early-stage companies have unproven business models and often lack stable revenue, leading to a high risk of failure. Market conditions, competition, and execution challenges can also impact the success of these startups.
• Reward: Venture capital investments can yield exponential returns if the startup achieves rapid growth and market dominance. Early entry into high-potential companies can lead to significant value creation as the company scales.

Learn more about private investment funds.

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Private Equity vs. Venture Capital

In today’s parlance, “private equity” has become synonymous with buyout investing. In this sense, the private equity style of investing is quite different from venture capital.

In private equity, firms target companies that are mature, have strong and predictable margins and cash flow, can support large debt loads, and have established track records.

This is quite different from venture capital investing, which typically focuses on investing in early stage companies who have little track record, negative profitability, but high growth potential.

To go deeper on this distinction, as well as careers in each area, check out my article on the key differences between private equity and venture capital.

Private Equity vs. Growth Equity

Typical private equity investing focuses on buyout investing, where firms take controlling stakes in mature firms with strong and stable cash flows.

There’s also a form of private equity investing that focuses on fast-growing companies called “growth equity.” In this growth-focused style, firms target companies that have high growth, are pre-IPO, and are at or approaching profitability.

Growth funds typically acquire a minority stake, whereas buyout funds acquire a controlling or majority stake.

For more, check out my article on key similarities and differences between private equity and growth equity — including in terms of career opportunities.

Types of Private Equity Firms

As discussed above, there are many strategies of private equity investing. However, there are also several types of firms within the industry.

These different types of firms also have slight nuances in their strategy. I profile each in the sections below:

• Mega funds
• Publicly traded funds
• Middle market funds
• Technology private equity

Mega Funds

Mega funds are the largest private equity funds in the industry. Most mega funds are relatively older firms with long and successful track records of buyout investing.

These firms typically have the largest fund sizes, are considered to be the most prestigious firms to work at, and have the highest compensation for employees.

Many of these funds are based in New York City or San Francisco; however, one hallmark of mega funds is that they’ve expanded quickly in recent years to have offices all over the world. Also, while many of these funds started by focusing on buyout investing, they’ve since expanded into other areas, launching funds that are dedicated to growth equity to venture capital to credit investing.

Prominent mega funds include:

• Blackstone Group
• Carlyle Group
• Apollo Global Management

If you’d like to go deeper, check out my article on mega funds here.

Publicly Traded Private Equity Firms

In recent years, many of the largest and most successful private equity firms have gone public via IPOs.

This has allowed the partners of these firms to cash out substantial amounts, while also providing the firms with a permanent capital base from which to expand into other areas of asset management.

In practice, the aforementioned mega funds have led the way in this area, and there is near 100% overlap between mega funds and publicly traded private equity firms.

To read more, check out my complete list of the publicly traded private equity firms.

Private Equity Middle Market Firms

Private equity firms that are smaller than mega funds are sometimes referred to as “middle market” private equity firms.

There’s no exact criteria for what constitutes “middle market,” but many would agree that a firm is middle market when they invest in deals that are valued below $5oo million.

Since this designation still leaves a broad category of firms, some draw distinctions between “upper middle market” (deals valued between $500 million and $1 billion) and “lower middle market” firms (deals valued between $10 million and $100 million).

While they typically do not pay as richly as mega funds, middle market firms still provide amazing career opportunities and very attractive pay. Compared to mega funds, there are several pros and cons associated with middle market firms.

Top middle market firms include:

• JMI Equity
• Alpine Investors
• Court Square

To go deeper, check out my deep dive into the middle market of private equity.

Technology Private Equity Firms

Many private equity firms choose to specialize in certain industries (e.g. healthcare, industrials, etc.).

However, in recent years, there have been several private equity firms that have specialized in technology and software investing. Usually, these industry areas are more commonly associated with growth-focused strategies, rather than buyout.

However, given the positive business model characteristics and the attractive opportunities, certain funds have brought a specialized approach to these areas.

Top software and technology private equity firms include:

• Silver Lake
• Vista Equity
• Hellman & Friedman

To read more, check out my complete list of the top technology and software private equity funds here.

Growth Private Equity Firms

Some private equity firms have elected to focus on investments where they earn their return primarily from acquiring minority stakes in fast growing companies.

This contrasts the usual targeting criteria for private equity firms — which focuses on slow growth companies with strong cash flow and an ability to support high debt burdens.

As discussed above, this form of private equity investing is popularly now known as “growth equity.”

Top firms in this area include:

• General Atlantic
• TA Associates
• Summit Partners

Go here for my deep dive on top growth equity firms.

Current Trends in Private Equity

The private equity landscape is continually evolving, influenced by shifts in economic conditions, regulatory environments, and investor priorities. Understanding these trends is essential for both founders and private equity professionals as they navigate this dynamic industry. Here are some of the most significant current trends shaping private equity today:

1. The Rise of ESG Investing

Environmental, Social, and Governance (ESG) considerations have become increasingly important in private equity investing. Investors are now more focused on ensuring that their investments not only generate financial returns but also contribute positively to society and the environment.

• Impact on Investment Decisions: Private equity firms are integrating ESG factors into their due diligence or PE investigation processes, portfolio management, and reporting practices. This trend is driven by both regulatory pressures and a growing demand from LPs for sustainable and responsible investing. Firms that embrace ESG principles are often better positioned to mitigate risks, improve long-term returns, and enhance their reputation among stakeholders.
• ESG as a Value Creation Tool: Beyond compliance, many private equity firms are leveraging ESG initiatives as a means of creating value within their portfolio companies. This includes improving energy efficiency, enhancing corporate governance practices, and fostering diversity and inclusion within management teams.

2. Technology-Driven Buyouts

The rapid pace of technological advancement is significantly impacting private equity strategies, particularly in sectors like software, fintech, and healthtech.

• Focus on Digital Transformation: Private equity firms are increasingly targeting companies that are either technology-based or poised for digital transformation. These firms are not only investing in tech startups but also acquiring traditional businesses and implementing technology upgrades to drive growth and efficiency.
• Data-Driven Decision Making: The use of big data and advanced analytics is becoming a critical component of private equity investing. Firms are using data-driven insights to identify investment opportunities, optimize operations in portfolio companies, and assess market trends more accurately.

3. Macroeconomic Factors: Interest Rates and Inflation

Macroeconomic conditions, particularly interest rates and inflation, are playing a pivotal role in shaping private equity strategies.

• Interest Rates: The recent fluctuations in global interest rates have influenced how private equity firms approach leverage in buyouts. With low-interest rates, firms have been able to finance deals more cheaply, leading to an increase in leveraged buyouts. However, as interest rates begin to rise, firms may face higher costs of debt, potentially impacting deal flow and returns.
• Inflation: Rising inflation is another critical factor, as it affects the cost structures and profitability of portfolio companies. Private equity firms are focusing on investments in sectors that can pass on price increases to customers or that benefit from inflationary environments, such as real assets or commodities. Additionally, firms are increasingly using hedging strategies to protect against inflationary pressures.

4. Growth of Private Credit

Private credit, or direct lending, has seen substantial growth as traditional banks pull back from lending to middle-market companies. Private equity firms are increasingly setting up their own credit arms to provide financing directly to businesses, offering an alternative to bank loans.

• Advantages of Private Credit: This trend allows private equity firms to have greater control over financing terms and provides a steady stream of income through interest payments. It also offers opportunities for firms to participate in both equity and debt sides of transactions, improving their influence over portfolio companies.

5. Globalization and Emerging Markets

Private equity is increasingly looking beyond developed markets for opportunities, with a growing focus on emerging markets.

• Expanding Geographies: As competition intensifies in traditional markets like the U.S. and Europe, firms are turning to Asia, Latin America, and Africa for growth opportunities. These regions offer attractive valuations, burgeoning consumer markets, and opportunities for significant operational improvements.
• Navigating Political and Economic Risks: Investing in emerging markets comes with unique challenges, including political instability, currency fluctuations, and regulatory differences. Private equity firms are increasingly building local expertise and partnerships to navigate these risks effectively.

Next Steps

Private equity is one of the most lucrative but also most competitive career paths to embark upon. Check out my full guide on how to break into private equity.