Private Equity: Definition, How It Works, and Types

What Is Private Equity?

Private equity is an investment approach where private equity firms use capital from investors and debt financing to buy companies, improve their performance, and sell them later for a profit. Private equity involves active ownership in private or delisted public companies and aims to generate higher returns through operational and financial improvements.

Private equity differs from publicly traded stocks because investors buy directly into private businesses or take public companies private. The defining feature is active ownership. Private equity (PE) firms acquire controlling stakes and work closely with management teams to improve profitability, efficiency, and the overall value of the business.

What Are the Main Private Equity Strategies?

Private equity strategies differ by the type of companies targeted, the level of control acquired, and the amount of debt used to finance investments. The four main private equity strategies are leveraged buyouts (LBOs), growth equity, venture capital, and distressed or special situations. 

Each approach uses a different balance of risk, return, and operational involvement. Together, these strategies make private equity a diverse investment class, ranging from mature business buyouts to early-stage innovation funding.

Leveraged Buyouts (LBOs)

A leveraged buyout (LBO) is a transaction where a private equity firm acquires a company primarily using borrowed funds. The acquired company’s assets and cash flows serve as repayment sources for the debt, allowing investors to increase returns while assuming higher financial risk. 

Buyout private equity firms target companies that usually have stable cash flows, proven business models, and opportunities for operational improvements.

Growth Equity

Growth equity occupies the middle ground between venture capital and buyouts. These funds invest in established companies experiencing rapid growth that need capital to scale operations, enter new markets, or make acquisitions. Growth equity investors typically take minority stakes and use less leverage than buyout funds.

Venture Capital

Venture capital funds invest in early-stage startups with high growth potential but limited access to traditional financing. While venture capital carries higher risk due to unproven business models, successful investments can generate extraordinary returns that offset losses from other failed ventures.

Distressed and Special Situations

Distressed funds specialize in companies facing financial difficulties or bankruptcy proceedings. These investors acquire businesses or liabilities at discounted valuations and work to restore profitability through operational turnarounds or balance sheet restructuring.  

In special situations, funds target events like corporate spin-offs, divestitures, or industry disruptions where strategic or structural changes can unlock value. These strategies often deliver strong returns when recovery efforts succeed.

How Do Private Equity Firms Work?

Private equity firms raise capital from institutional investors, combine it with debt financing, and use those funds to buy companies. Over an average holding period of four to seven years, they improve operations, grow revenue, and then sell the company for a higher value.

Success in private equity requires expertise in deal sourcing, valuation, financial structuring, and operational management. The goal is to generate strong risk-adjusted returns for investors through both financial and operational improvements.

Private Equity Investors: General Partners and Limited Partners

Private equity funds have two main types of investors: General Partners (GPs) and Limited Partners (LPs).

• General Partners (GPs): GPs manage the fund, make investment decisions, and oversee portfolio companies. They contribute 1–3% of total capital, charge management fees, and earn a share of profits known as carried interest.
• Limited Partners (LPs): LPs provide 97–99% of the capital but have no control over management decisions. LPs typically include pension funds, insurance companies, endowments, and accredited investors — institutions and individuals that meet requirements for net worth, annual income, or professional experience.

This structure aligns incentives between both groups: GPs are motivated to grow returns, while LPs benefit from professional fund management and access to private equity opportunities.

Finding and Evaluating Investment Opportunities

Private equity firms find and evaluate investments through a two-step process: deal sourcing and due diligence. They identify potential targets through investment banks, business brokers, professional networks, and direct outreach to company owners.

Once a company is identified, the firm conducts due diligence to assess financial performance, growth prospects, and management strength. Analysts build detailed financial models to estimate potential returns and exit value. This process helps firms select investments that meet return targets and align with their expertise.

Acquisition Financing

Private equity firms finance acquisitions primarily through leveraged buyouts (LBOs), where 50-70% of the purchase price is funded with borrowed money, and the remaining 30–50% comes from the PE firm’s own equity. This debt financing can amplify returns when the company’s value increases after operational improvements.

Example:

• Purchase price: $100 million company
• PE firm’s money: $30 million (30%)
• Borrowed money: $70 million (70%)
• Sales proceeds after improvements: $150 million
• Repay loans: $70 million
• Profit: $50 million
• Return on PE firm’s investment: 167% ($50M profit ÷ $30M invested)

This strategy works best with mature, cash-generating businesses that can service debt payments while the private equity firm enhances operations. By using leverage, firms can achieve higher returns on a smaller equity base.

Increasing the Value of Businesses

Private equity firms create value by improving the performance, profitability, and long-term potential of the companies they acquire. Value creation combines operational improvements, strategic initiatives, and financial discipline to increase a company’s worth before it is sold.

Key strategies include:

• Revenue growth through new product lines, market expansion, or pricing improvements.
• Cost reduction through efficiency gains, technology upgrades, and improved procurement.
• Strategic repositioning to focus on higher-margin or faster-growing business segments.
• Management upgrades that strengthen leadership and execution capabilities.

Private equity firms often work closely with management teams to implement these initiatives. Some firms take an active operational role, while others provide strategic oversight and support. The ultimate goal is to grow company value, achieve higher cash flows, and deliver superior returns to investors at exit.

How Do Private Equity Firms Exit Investments?

Private equity firms exit investments by selling portfolio companies or taking them public to realize returns for investors. These exit strategies, often called liquidity events, allow firms to convert ownership stakes into cash once value has been created.

The main exit options include:

• Strategic sale: Selling the company to another business in the same industry.
• Secondary buyout: Selling the company to another private equity firm.
• Initial Public Offering (IPO): Listing the company’s shares on a public exchange.
• Dividend recapitalization: Having the company borrow funds to pay cash dividends to investors before a full sale.

The choice of exit depends on market conditions, company performance, buyer interest, and return objectives. The goal in every case is the same: to capture the gains from operational and strategic improvements made during the holding period.

Private Equity Buyout Example: Jersey Mike’s Subs

The acquisition of Jersey Mike’s Subs by Blackstone in 2024 illustrates how private equity firms use capital and operational expertise to expand successful brands. The deal, valued at about $8 billion including debt, gave Blackstone a majority ownership stake. Founder and CEO Peter Cancro retained significant equity and continued to lead the company.

Blackstone’s investment strategy focuses on domestic and international franchise expansion and digital transformation to enhance growth. By combining management continuity with new capital and strategic guidance, the firm aims to increase revenue and long-term enterprise value.

This example shows how private equity firms often partner with strong management teams rather than replacing them, supporting operational improvements and growth initiatives that create higher returns at exit.

Why Invest in Private Equity?

Investors choose private equity because it offers the potential for higher returns, portfolio diversification, and access to professional management that focuses on improving company performance. 

• Higher return potential: Private equity investments have historically produced stronger returns than public stock markets. By combining borrowed money with business improvements, firms can increase company value and target annual returns of 20–30% for top-performing funds.
• Portfolio diversification: Private equity gives investors exposure to companies not traded on public exchanges, reducing dependence on traditional stocks and bonds. This helps spread risk across different types of assets.
• Professional management: Limited partners rely on private equity firms to identify opportunities, improve operations, and manage investments. Investors benefit from the firm’s experience, research, and active oversight.

Investment Trade-Offs and Limitations

However, investing in private equity comes with trade-offs. Funds are typically locked in for seven to ten years, with minimum investments often starting at $1 million to $10 million. Investors also pay management and performance fees, which cover the cost of managing and growing the fund. 

Despite these limits, many institutions continue to invest because private equity has historically rewarded long-term patience and professional oversight with strong performance over time. 

How Is Private Equity Regulated?

Many private equity fund managers in the U.S. are regulated under the Investment Advisers Act of 1940 and must register with the SEC unless they meet an exemption or fall under state regulation. Meanwhile, the funds themselves often qualify for exemptions under the Investment Company Act of 1940, which allows them to limit investor eligibility to institutional investors or accredited investors and avoid public fund registration. 

Regulatory frameworks vary internationally. In the European Union, the Alternative Investment Fund Managers Directive (AIFMD) regulates managers of private equity, venture capital, and other alternative investment funds. AIFMD includes transparency, risk management, reporting, and investor protection obligations for private equity managers operating or marketing funds within the EU.

The Bottom Line on Private Equity

Private equity is a form of investing where firms acquire companies or buy ownership stakes with the goal of improving their performance and selling them later for a profit. It offers investors the potential for higher returns than public markets but requires patience, large capital commitments, and acceptance of long lock-up periods.

Private equity firms create value by actively managing the companies they own, strengthening operations, and pursuing growth opportunities before exiting through a sale or public offering. This active ownership model allows investors to participate in company improvements that drive long-term gains, though it also comes with higher risk and less liquidity than traditional investments.

In short, private equity combines strategic ownership, financial expertise, and long-term focus to generate returns that reward both firm performance and investor commitment.

Frequently Asked Questions: Private Equity

What is the difference between private equity and venture capital?

Private equity firms invest in established, mature companies with proven business models, typically acquiring controlling stakes and using significant borrowed money. Venture capital firms focus on riskier early-stage startups with high growth potential, taking minority equity positions without leverage.

How much money do you need to invest in private equity?

Most private equity funds are open only to institutional and accredited investors because of their high minimum investment requirements. The minimum investment is typically between $1 million and $10 million, though some funds require even more. These high thresholds limit access to pension funds, endowments, insurance companies, and high-net-worth individuals.

How long do private equity investments last?

Private equity investments are long-term commitments. Firms usually hold portfolio companies for four to seven years, while an entire fund often lasts 10 to 12 years from the time it raises money to when it sells its final investment. Investors generally cannot withdraw their capital early, since funds must stay invested until exits occur.

How do private equity firms make money?

Private equity firms make money from two main sources: management fees and performance-based profits (often called carried interest). Management fees, usually around 2% of total committed capital per year, cover operating costs and salaries. Carried interest represents about 20% of the fund’s profits and rewards strong performance when investments are successfully sold or taken public.

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Additional Resources

Private Equity Funds

Growth Equity

Private Equity Career Profile

Private Equity Salary Guide

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