Private Equity: What It Is and How It Works

Private equity (PE) firms manage trillions of dollars and own household names from Dunkin' to Hilton. But how does this world actually work?

What Is Private Equity?

Private equity is an investment strategy that involves: 1. Raising capital from institutional investors and wealthy individuals 2. Using that capital (plus borrowed money) to buy companies 3. Improving those companies over 3-7 years 4. Selling them for a profit

The key word is "private" – these are companies not traded on public stock exchanges.

How PE Firms Make Money

For Their Investors

PE firms aim to generate returns of 15-25%+ annually through:

• Buying companies at attractive prices
• Improving operations and growth
• Using leverage to amplify returns
• Selling at higher valuations

For Themselves

PE firms typically charge:

• **Management fee:** 1.5-2% annually on committed capital
• **Carried interest:** 20% of profits above a hurdle rate

A $10 billion fund might generate $200 million/year in management fees alone.

Types of Private Equity Strategies

Leveraged Buyouts (LBOs)

The classic PE strategy: 1. Buy a mature company 2. Use significant debt (60-70% of purchase price) 3. Improve operations, cut costs, grow revenue 4. Sell or take public in 5-7 years

The debt amplifies returns if successful (and losses if not).

Growth Equity

Minority investments in fast-growing companies that need capital to expand. Less control, less leverage, different risk/return profile.

Venture Capital

Technically a type of PE focused on early-stage startups. Higher risk, potentially higher returns.

Distressed Investing

Buying troubled companies or their debt at deep discounts, then restructuring.

How PE Creates Value (In Theory)

Operational Improvements

• Better management
• Streamlined operations
• Cost cutting
• Strategic acquisitions

Financial Engineering

• Optimizing capital structure
• Tax efficiency
• Dividend recapitalizations

Multiple Expansion

Buying at 8x earnings, selling at 12x earnings – even without improving the business.

Revenue Growth

Investing in sales, marketing, and expansion.

The Reality Check

Not All PE Is Created Equal

• Top-quartile firms significantly outperform
• Bottom-quartile firms destroy value
• Manager selection is crucial

After Fees, Returns Are More Modest

Academic research suggests:

• Gross returns have been strong historically
• Net returns (after fees) often comparable to public markets
• The "PE premium" may be smaller than advertised

Leverage Cuts Both Ways

The debt that amplifies gains also amplifies losses. PE investments can and do lose money.

Can Individual Investors Access PE?

Traditional Access: Difficult

• Accredited investor requirement
• Minimums of $250,000 - $10 million+
• 10-year lock-up periods
• Capital calls over time

Newer Options

**Feeder Funds:** Platforms like iCapital, Moonfare offer lower minimums ($50,000-$100,000).

**Interval Funds:** Semi-liquid PE funds with lower minimums.

**PE ETFs/Funds:** Invest in publicly traded PE firms (Blackstone, KKR, Apollo).

**Secondaries Market:** Buy existing PE stakes (still requires significant capital).

Should You Invest in PE?

Potential Benefits

• Different return drivers than public markets
• Access to private company growth
• Historically strong returns (top managers)

Significant Concerns

• High fees (2 and 20)
• Illiquidity (locked up for years)
• Manager selection risk
• Leverage risk
• Less transparent than public markets

For Most Investors

The honest truth: Most people are better served by low-cost public market investments.

PE makes sense for:

• Large portfolios ($1M+) seeking diversification
• Long time horizons
• Investors who can accept illiquidity
• Those with access to top-tier managers

The Billionaire Factory

PE has created enormous wealth for its practitioners:

• Blackstone's Steve Schwarzman
• KKR's Henry Kravis
• Apollo's Leon Black
• Carlyle's David Rubenstein

This doesn't mean their investors always win – fee structures guarantee firms profit even in mediocre outcomes.

The Bottom Line

Private equity is a legitimate investment strategy that has created real value in many cases. But:

1. **Fee drag is real:** 2% + 20% is expensive 2. **Illiquidity matters:** Can you really not touch money for 10 years? 3. **Manager selection is everything:** Average PE barely beats public markets 4. **Public alternatives exist:** Invest in publicly traded PE firms instead

For most individual investors, the publicly traded stock market offers diversification, liquidity, and low costs that are hard to beat – even by the most sophisticated private equity managers.