What is Private Equity? Non-Public Company Investing

Private equity represents one of the most powerful and misunderstood investment strategies in modern finance. While most investors focus on publicly traded stocks and bonds, private equity firms deploy hundreds of billions of dollars annually to acquire, transform, and sell private companies—generating returns that have historically outperformed public markets. From leveraged buyouts that take public companies private to growth capital investments in emerging businesses, private equity plays a crucial role in corporate finance and wealth creation.

Whether you're an entrepreneur considering private equity funding, an investor exploring alternative investments, or simply curious about this influential asset class, understanding private equity is essential for comprehending modern capital markets. This comprehensive guide will explain what private equity is, how it works, the different investment strategies, risks and returns, and how both institutional and individual investors can access this historically exclusive asset class.

What is Private Equity?

Private equity refers to investment capital that is used to acquire equity ownership in private companies—businesses not traded on public stock exchanges. Private equity firms raise capital from institutional investors (pension funds, endowments, insurance companies) and wealthy individuals, pool this capital into funds, then use these funds to purchase stakes in or complete ownership of private businesses. The goal is to improve these companies' operations and value over several years, ultimately selling them for substantial profits.

Unlike public market investors who buy minority stakes in publicly traded companies and have limited influence, private equity investors typically acquire controlling stakes or complete ownership, giving them power to fundamentally transform how companies operate. They install new management, restructure operations, implement strategic initiatives, optimize capital structure, and guide companies toward specific performance milestones—all with the goal of maximizing value at exit.

The Core Characteristics of Private Equity

• Private companies: Investments are in companies not publicly traded, requiring different valuation methods and offering no daily price quotes
• Active ownership: PE firms take control and actively manage portfolio companies rather than being passive shareholders
• Leverage: Acquisitions typically use significant debt (50-70% of purchase price) to amplify returns
• Finite investment period: PE funds have defined lifespans (typically 10 years) with specific investment and harvesting periods
• Illiquidity: Investors commit capital for years without redemption rights, receiving returns only when companies are sold
• Performance fees: PE firms typically charge 2% annual management fees plus 20% of profits (called "carried interest" or "carry")

How Private Equity Creates Value

Private equity firms create value and generate returns through several mechanisms:

1. Operational Improvements: PE firms bring operational expertise, industry best practices, and strategic guidance. They install new management teams, streamline operations, cut costs, improve margins, expand into new markets, and implement growth initiatives. These operational enhancements increase profitability and company value.

2. Financial Engineering: By using leverage (debt) to finance acquisitions, PE firms amplify returns on their equity. If a firm invests $200M of equity and $300M of debt to buy a $500M company, and later sells it for $800M after paying down debt to $250M, the equity value grows from $200M to $550M—a 2.75x return. Without leverage, the same absolute profit would yield only a 1.6x return.

3. Multiple Arbitrage: PE firms often buy companies at lower valuation multiples (perhaps 6x EBITDA) and sell at higher multiples (8-10x EBITDA), either because they've repositioned the company, because they're selling to strategic buyers who value synergies, or because market conditions have improved.

4. Buy and Build: Firms acquire platform companies, then make additional "add-on" acquisitions of smaller companies to build larger, more valuable platforms. Five $50M companies might sell for 6x EBITDA each, but consolidated into a $250M company, the combined entity might command 9x EBITDA, creating value from scale and consolidation.

Types of Private Equity Strategies

Private equity encompasses several distinct investment strategies, each with different risk-return profiles and company characteristics.

Leveraged Buyouts (LBOs)

The largest and most iconic private equity strategy involves acquiring established, profitable companies using significant debt financing. LBO targets are typically mature businesses with stable cash flows, strong market positions, and predictable revenues— characteristics that support debt service.

How LBOs work: A PE firm identifies a target company worth $500M. Instead of investing $500M of equity, the firm puts up $150M equity and borrows $350M. Over 5 years, the company's cash flow pays down debt to $250M while operational improvements and growth increase the company's value to $700M. When sold, debt is repaid, leaving $450M for equity investors—a 3x return on the initial $150M investment.

Target characteristics: Stable cash flows, low capital requirements, strong market positions, opportunities for margin improvement, management team enhancement, or strategic repositioning.

Growth Equity

Growth equity invests in established, growing companies that need capital to scale but aren't ready for or don't want traditional buyouts. Unlike venture capital, growth equity targets companies with proven business models and positive cash flow that need funding for expansion, acquisitions, market entry, or product development.

Investment characteristics: Minority or majority stakes, companies typically generating $10M-$100M+ in revenue, less leverage than LBOs, focus on revenue growth rather than cost cutting, and shorter hold periods (3-5 years) than traditional PE.

Venture Capital

While technically a subset of private equity, venture capital (VC) deserves separate discussion. VC invests in early-stage, high-growth startups trading higher risk for potentially exponential returns. VC-backed companies are typically unprofitable, investing heavily in growth, and have unproven business models but significant growth potential.

Distressed Investing and Special Situations

Distressed PE funds acquire struggling or bankrupt companies at discounted prices, then work to turn them around. This requires different expertise than traditional PE— restructuring, bankruptcy law, operational turnarounds, and stakeholder negotiations. Higher risk and complexity can generate higher returns when executed successfully.

Secondaries and Co-Investments

Secondary funds purchase existing LP interests in PE funds from investors wanting liquidity before fund maturity. Co-investments involve LPs investing directly alongside PE funds in specific deals, typically without paying management fees or carry on the co-invested capital.

Why Private Equity Matters for Investors and the Economy

Understanding private equity is crucial because it influences markets, generates wealth, and shapes corporate America. Here's why PE matters:

• Superior Historical Returns: Top-quartile PE funds have historically delivered 15-25% annual returns, outperforming public equity markets. While averages are more modest (10-15%), the potential for exceptional returns attracts institutional capital. A pension fund investing $100M in a PE fund earning 20% annually accumulates $249M in 5 years versus $203M at 15% in public markets—that $46M difference compounds over decades.
• Diversification Benefits: PE returns have low correlation to public markets because valuations are less affected by daily market volatility, investments span different economic cycles, and value creation comes from operational improvements rather than market sentiment. This non-correlation enhances portfolio risk-adjusted returns.
• Access to Private Market Opportunities: Many excellent businesses remain private—either family-owned, private equity-owned, or startups not yet public. PE provides access to this massive private economy representing trillions in enterprise value that public market investors cannot access.
• Alignment of Interests: PE fund structures align investor and manager interests. General partners invest their own capital alongside LPs, earn carried interest only when investors profit, and face reputational risk if funds underperform. This alignment contrasts with public company executives whose compensation may not depend on long-term shareholder returns.
• Long-Term Value Creation: Freed from quarterly earnings pressure, PE-owned companies can make long-term investments in technology, talent, and transformation that public companies often avoid. This patient capital enables value creation strategies requiring years to materialize.
• Economic Impact: PE-backed companies employ millions of workers, drive innovation, consolidate fragmented industries, rescue failing businesses, and return capital to investors like pension funds that pay retiree benefits. Critics argue PE can involve excessive leverage and cost-cutting, but proponents note PE improves company performance and competitiveness.

In practice, understanding PE helps investors evaluate whether the illiquidity, high minimums, and complexity justify the potential returns and diversification. For pension funds managing 30-year liabilities, locking up 15-20% of assets in PE for superior returns makes sense. For individual investors needing liquidity, PE access may be impractical despite attractive returns.

The Private Equity Fund Structure

Private equity operates through a specialized fund structure with distinct roles and economics:

General Partners (GPs) and Limited Partners (LPs)

General Partners are the PE firm professionals who manage the fund, source deals, conduct due diligence, execute transactions, manage portfolio companies, and orchestrate exits. GPs typically contribute 1-3% of total fund capital.

Limited Partners are the investors—pension funds, endowments, insurance companies, sovereign wealth funds, and wealthy individuals—who provide the bulk of capital but have no operational control.

The 2-and-20 Fee Structure

PE compensation traditionally follows a "2 and 20" model:

Management Fee (2%): LPs pay annual fees of 1.5-2% of committed capital during the investment period, then 1.5-2% of invested capital or NAV during the harvesting period. These fees cover fund operations, deal sourcing, and portfolio management.

Carried Interest (20%): GPs receive 20% of fund profits above a "hurdle rate" (typically 8%). If a fund returns $1.5B to LPs who invested $1B, the profit is $500M. Of this, GPs receive $100M (20%) and LPs receive $400M (80%). Carry aligns GP and LP interests since GPs profit only when LPs profit.

Capital Calls and Distributions

Unlike mutual funds where investors invest lump sums, PE operates on a "capital call" system:

• LPs commit capital ($10M, for example) when investing in a fund
• Capital remains with LPs earning returns until needed
• When the GP identifies investments, they "call" capital from LPs, who must send funds within days
• Capital is called over several years as deals are executed
• Returns are distributed to LPs when companies are sold, typically 4-7 years after initial investment

Fund Lifecycle

Typical PE funds follow a 10-year lifecycle:

• Years 0-1: Fundraising period where GPs raise capital from LPs
• Years 1-5: Investment period where GPs deploy capital into companies
• Years 3-10: Harvesting period where companies are improved and sold
• Years 10+: Optional extensions (1-2 years) to exit remaining investments

Risks and Challenges in Private Equity

Despite attractive potential returns, private equity involves significant risks:

Illiquidity Risk

Capital is locked up for 10+ years with no ability to redeem early. This illiquidity means investors must be certain they won't need funds during the investment period. Selling LP interests on secondary markets is possible but typically requires accepting significant discounts to NAV.

Leverage Risk

High debt levels amplify returns but also amplify losses. If a portfolio company underperforms and cannot service debt, it may face bankruptcy, wiping out equity value. The 2008 financial crisis showed how leverage can devastate PE returns when credit markets freeze and company performance deteriorates simultaneously.

Valuation Uncertainty

Without daily market prices, PE valuations are subjective estimates based on comparable transactions, DCF models, or EBITDA multiples. Valuations may be optimistic, and actual exit prices can differ significantly from interim valuations, creating uncertainty about true performance until realization.

Manager Selection Risk

Performance varies dramatically among PE managers. Top-quartile funds may return 20%+ while bottom-quartile funds may underperform public markets or lose money. Selecting the right managers is crucial but difficult—past performance doesn't guarantee future results, and access to top funds is limited.

J-Curve Effect

PE funds typically show negative returns in early years as fees are paid and investments are made at cost, while value creation hasn't yet materialized. Returns turn positive only years later when companies are sold. This "J-curve" means investors must be patient and financially stable enough to wait years for positive returns.

How Individual Investors Can Access Private Equity

Historically limited to institutions and ultra-wealthy, PE is becoming more accessible:

Direct Fund Investment

Accredited investors with $1M+ net worth (excluding primary residence) or $200K+ annual income can invest directly in PE funds, though minimums typically range from $250,000 to $10M+. This requires significant capital, long lock-up tolerance, and ability to meet capital calls on demand.

Funds of Funds

These vehicles pool capital from multiple investors to gain access to numerous PE funds, providing diversification and lower minimums (sometimes $25,000-$100,000). However, they charge additional fees (1% management fee plus 5-10% performance fee), layering costs on top of underlying PE fund fees.

Publicly Traded PE Firms

Companies like Blackstone (BX), KKR (KKR), Apollo (APO), Carlyle (CG), and Ares (ARES) trade publicly. Buying shares provides exposure to PE firm management fees and carried interest rather than direct PE returns, but offers liquidity and accessibility. Performance correlates with but differs from underlying PE fund returns.

Interval Funds and Tender Offer Funds

These '40 Act structures allow periodic redemptions (quarterly or monthly) with lower minimums ($2,500-$25,000), making PE accessible to non-accredited investors. They sacrifice some return potential for liquidity and accessibility but democratize PE investing.

Private Equity ETFs

ETFs holding publicly traded PE firms or private company stocks provide liquid, low-minimum PE exposure. However, they don't replicate true PE returns—they're essentially equity funds focused on PE-related companies rather than genuine private equity investments.

Conclusion

Private equity represents a powerful investment strategy that has generated substantial wealth for institutional investors and transformed thousands of companies over decades. By acquiring controlling stakes in private businesses, implementing operational improvements, and leveraging financial engineering, PE firms create value that has historically outperformed public markets.

However, this performance comes with significant trade-offs. Illiquidity locks capital up for a decade or more, high leverage amplifies both gains and losses, manager selection heavily influences outcomes, and traditional PE access requires substantial wealth and capital commitments. For investors with appropriate risk tolerance, time horizon, and capital, PE offers diversification and return potential that can enhance portfolio performance.

The democratization of PE through interval funds, funds of funds, and other structures is making this asset class increasingly accessible. Yet investors should approach carefully, understanding that lower-minimum vehicles often sacrifice some return potential for accessibility and liquidity. As with all alternative investments, private equity should complement rather than replace core holdings in stocks and bonds.

Remember: Private equity rewards patient, sophisticated investors who can tolerate illiquidity and have the capital to properly diversify. It's a marathon, not a sprint— but for those with the appropriate circumstances, it can be a powerful component of long-term wealth building.