What is private equity and how does it work?

Whether you realize it or not, many of the goods, services, and products you use every day are from private equity-backed companies. Grabbing dog food at PetSmart? It’s private equity-backed. Picking up Arby’s or Panera Bread on the way home? Yep, those are PE-backed, too. Looking into your family history with Ancestry? PE is all around us all the time.

But what exactly is private equity? A foundational concept for anyone interested in learning about—or working in an industry tangential to—the private markets, this article breaks down the basics of PE.

What is private equity?

Private equity (PE) is a form of financing where money, or capital, is invested into a company. Typically, PE investments are made into mature businesses in traditional industries in exchange for equity, or ownership stake. PE is a major subset of a larger, more complex piece of the financial landscape known as the private markets.

PE is an alternative asset class alongside real estate, venture capital, distressed securities, and more. Alternative asset classes are considered less traditional equity investments, which means they are not as easily accessed as stocks and bonds in the public markets. We dedicated an entire article outlining the difference between the public and private sectors.

The history of private equity

What we think of today as private equity dates back to the 1940s with the creation of the first-ever venture capital firms established after World War II. The “father of venture capitalism” Georges Doriot founded the American Research and Development Corporation (ARDC), one of those early VC firms, in 1946. His aim was to provide private investments for businesses operated by soldiers returning from war.

The first venture-backed startup was funded in 1959, and the first PE fund—still in use today—was launched in 1960. Still, there was limited awareness or understanding of the industry and few firms through the 1970s.

At around the same time, the first leveraged buyout is thought to have taken place in 1955—completed by McLean Industries, Inc. Using publicly traded holding companies as investment vehicles to acquire portfolios of investments became the new trend in 1960s, brought into the mainstream by the likes of Warren Buffet and others. And these private market players are considered the forerunners of more modern private equity firms.

The first private equity boom lasted from the early 1980s through the early 1990s, characterized by peoples’ growing awareness of PE’s ability to impact companies they knew. The big boom’s grand finale was the leveraged buyout of RJR Nabisco—which would remain the largest LBO for nearly two decades.

How does private equity work?

To invest in a company, private equity investors raise pools of capital from limited partners (LPs) to form a fund. Once they’ve hit their fundraising goal, they close the fund and invest that capital into promising companies. PE investors may invest in a company that’s stagnant or distressed, but still shows signs for growth potential.

When a PE firm sells one of its portfolio companies to another company or investor, the firm usually makes a profit and distributes returns to LPs that invested in its fund. Some PE-backed companies may also go public.

What is a private equity investor?

Investors working at a private equity firm are called private equity investors. They are critical to raising capital, as well as identifying companies that present good investment opportunities. PitchBook tracks global investors, including more than 17,000 whose primary investor type is private equity as of June 2024.

What are the 3 main strategies for PE investments?

We’ve outlined the three main strategies for PE investments below. It’s important to note that many private equity investors are adapting their tried-and-true investment strategies at present given current market uncertainties.

Buyout

A buyout is when an investor purchases a majority stake in a company. The most common deal type is a leveraged buyout (LBO). In fact, LBOs accounted for 66% of all PE deals in 2021, and the median deal size for LBOs in 2021 was $101 million. In a leveraged buyout, an investor purchases a controlling stake in a company using a combination of equity and a significant amount of debt, which must eventually be repaid by the company. In the interim, the investor works to improve profitability so that the debt repayment is less of a financial burden for the company.

Growth

Sometimes, instead of purchasing a majority stake in a company, an investor will acquire a minority stake, looking to further grow the company. This type of investment is similar to VC investments in that no debt is used and only a minority stake is given in exchange for capital. These investments typically take place at the intersection of VC and PE, where companies are still growing but may have already proven some profitability. Growth financing accounted for 11% of all PE deals in 2021, and the median deal size was $30 million.

Mezzanine

Mezzanine is a unique strategy within PE—it bridges the gap between debt and equity. When a company receives mezzanine financing from a private equity group, it takes on debt (capital with the agreement to pay it back, plus interest) that includes some “embedded equity.” Essentially, that means that the debt can be converted into equity. Sometimes warrants are attached, which allow the lender to purchase equity at a set price at a later date while keeping the original debt. Sometimes mezzanine debt is taken on by itself, and other times, it is in conjunction with another transaction—mostly LBOs.

What is a private equity firm?

A private equity firm is a type of investment firm. They invest in businesses with a goal of increasing their value over time before eventually selling the company at a profit. Similar to venture capital firms, PE firms use capital raised from limited partners (LPs) to invest in promising private companies.

Unlike VC firms, PE firms often take a majority stake—50% ownership or more—when they invest in companies. Private equity firms usually have majority ownership of multiple companies at once. A firm’s array of companies is called its portfolio, and the businesses themselves are portfolio companies.

How do private equity firms make money?

PE funds collect both management and performance fees. These can vary from fund to fund, but the typical fee structure follows the 2-and-20 rule.

What are management fees?

Calculated as a percentage of assets under management or AUM, typically around 2%, these fees are intended to cover daily expenses and overhead and are incurred regularly.

What are performance fees?

Calculated as a percentage of the profits from investing, typically around 20%, these fees are intended to incentivize greater returns and are paid out to employees to reward their success.

Top 5 global private equity firms by number of investments (2019–present)

The five PE firms highlighted below have made the most investments over the last five years, from 2019 through present, as of June 18, 2024. In performing a PitchBook Platform search, our clients can use the Investors & Funds Screener and then select “PE Investors” from the drop-down menu to see the same data. For this article, we’ve selected “Search for primary investor type only” on the Investor Type tab of our search.

Note that PitchBook’s data is dynamic and subject to change often, with new investments and deals data added daily. The information below represents a snapshot in time and will become outdated as new data becomes available.

1. Kohlberg Kravis Roberts (KKR)

💰 Number of investments: 992
⚡️Primary investment type: PE/buyout
📈 Assets under management: $578B

Headquartered in New York City, KKR is a private equity investment firm that was founded in 1976. The firm prefers to invest in alternative asset classes including real estate, infrastructure, and credit through strategic partnerships and hedge funds. Companies the firm has recently invested in include Mirastar, Busan City Gas, and Hubble Technology.

2. Insight Partners

💰 Number of investments: 891
⚡️Primary investment type: Growth/expansion
📈 Assets under management: $89.3B

New York City-based Insight Partners is a growth and expansion firm that invests across B2B, B2C, logistics, government services, fintech, and more. The firm was founded in 1995, and it currently has $11.2 billion of dry powder. Most recently, Insight Partners has invested in Canary Technologies, Cirsium Biosciences, and Cognigy.

3. The Carlyle Group

💰 Number of investments: 861
⚡️Primary investment type: PE/buyout
📈 Assets under management: $425B

Founded in 1987, The Carlyle Group is a private equity firm headquartered in Washington, DC. The firm invests in companies within aerospace, government services, commercial products, financial services, healthcare, and more. Companies the firm has recently invested in include Persuasion Technologies, Seattle Reign FC, and Ecorbit.

4. HarbourVest Partners

💰 Number of investments: 829
⚡️Primary investment type: PE/buyout
📈 Assets under management: $151.4B

Boston-based HarbourVest Partners is a PE firm founded in 1982. The firm prefers to invest via buyouts, management buyouts, add-ons, mezzanine, debt, and growth capital, and it has $32.1B of dry powder on hand. Most recently, HarbourVest Partners has made investments in ACG Insurance Brokers, Iron Capital Advisors, and Italiano Insurance Services.

5. Shore Capital Partners

💰 Number of investments: 795
⚡️Primary investment type: PE/buyout
📈 Assets under management: $7B

Chicago’s Shore Capital Partners is a PE firm founded in 2009. The firm invests in companies within the healthcare, food and beverage, business services, and real estate sectors in the US. Companies Shore Capital Partners has recently invested in include PrincetonOne, Pritzlaff Wholesale Meats, and Berry & Company.

What is a private equity fund?

A PE fund is a pool of capital raised by PE investors and sourced from LPs.

PE funds vs. hedge funds

Both private equity funds and hedge funds are restricted to accredited investors. However, the biggest differences between PE funds and hedge funds are fund structure and investment targets. Hedge funds tend to operate in the public markets, investing in publicly-traded companies while PE funds focus on private companies.

PE funds vs. mutual funds

The biggest differences between PE funds and mutual funds are where capital comes from, the types of companies the fund invests in and how the firm collects fees. PE funds raise capital from LPs, which are accredited, institutional investors and mutual funds leverage capital from everyday investors. PE funds typically invest in private companies whereas mutual funds typically invest in publicly-traded companies. And mutual funds are only allowed to collect management fees, whereas PE funds can collect performance fees.

What’s the difference between private equity and venture capital?

Private equity refers to investments or ownership in private companies. It’s also used as a term for the PE strategy of investing. Venture capital investments are a form of PE investment that tend to focus more on early-stage startups. So, VC is a form of private equity; here are some additional distinctions between PE and VC.

Unique characteristics of private equity

• PE firms often invest in mature businesses in traditional industries.
• Using capital committed from LPs, PE investors invest in promising companies—typically taking a majority stake (>50%)
• When a PE firm sells one of its portfolio companies to another company or investor, returns are distributed to the PE investors and to the LPs—investors typically receive 20% of the returns, while LPs get 80%

Unique characteristics of venture capital

• VC firms often invest in tech-focused startups and other young companies in their seed
• Using committed capital, VC investors usually take a minority stake (<50%) in the companies they invest in
• Most of these companies are not fully established or profitable, so they can be risky investments—but with that risk comes the opportunity for big returns
• The firm makes a profit if a company they’ve invested in goes public or gets acquired, or by selling some of its shares to another investor on the secondary market