The Beginner’s Guide To Understanding Private Equity

Private equity is an alternative investment strategy where firms raise capital to invest in or acquire companies with the goal of generating high returns. This comprehensive guide will take you through everything you need to know about private equity as a beginner.

Private equity (PE) involves firms pooling capital from investors to acquire controlling stakes in private companies or take public companies private. The firms then work to improve operations and grow the business before eventually exiting the investment at a profit after several years.

Private equity is an important asset class that allows investors to gain exposure to opportunities outside of the public markets. It has gained prominence due to its ability to generate higher returns compared to traditional investments, albeit with higher risk.

Key Takeaways:

Point	Description
What is Private Equity?	Firms raise funds to acquire controlling stakes in companies with the aim of improving operations and eventually exiting at a higher valuation.
Investment Horizon	PE firms typically hold investments for 4-7 years before exiting.
Return Profiles	Private equity targets higher absolute returns than public markets but also carries higher risk.
Liquidity	PE investments are illiquid and capital is locked up for the life of the fund.
Investor Base	PE funds raise capital from institutional and accredited investors like pensions, endowments, etc.

What is Private Equity?

Private equity refers to investment firms that acquire private or public companies by pooling capital from various investors. The term “private equity” stems from the private or non-publicly traded nature of the companies involved.

PE has its origins dating back to the late 1800s, but the industry took off in the 1970s and 1980s with the boom in leveraged buyouts (LBOs). Major PE firms like KKR, Blackstone, and Carlyle were founded during this period.

Key Private Equity Terms

• General Partner (GP): The private equity firm making the investments and managing the fund.
• Limited Partners (LPs): The investors who commit capital to the PE fund.
• Management Fee: Annual fee (typically 2%) charged by the GP to LPs to cover operations.
• Carried Interest: Share of profits (usually 20%) that the GP receives as a performance fee.
• Dry Powder: Committed capital that has not yet been invested or called.
• Internal Rate of Return (IRR): Metric used to measure annual returns generated by a fund.

Recommended: The Risks And Returns Of Private Equity Investments

Types of Private Equity Investments

While the term “private equity” is often associated with buyouts of mature companies, the investment types span various stages:

The core role of PE firms is to deploy capital from their investment funds to acquire stakes in companies they see as undervalued. They then work closely with the company’s management team to implement operational improvements and grow the business.

Some key operational value-creation strategies employed include:

• Cost-cutting and efficiency improvements
• Entering new markets or product expansion
• Strategic acquisitions or mergers
• Improved corporate governance and financial controls
• Capital expenditure to drive growth

After holding the investment for several years, the PE firm will look to exit by selling the company through an IPO listing, a sale to another PE firm, or a strategic buyer.

The Private Equity Investment Process

Below is the Investment Process for Private Equity:

Fundraising and Securing Commitments

The private equity process begins with setting up and raising capital for an investment fund. Top PE firms can raise funds as large as $10+ billion by securing commitments from:

• Pension funds
• Sovereign wealth funds
• Endowments and foundations
• Family offices and high-net-worth individuals
• Fund of funds

PE funds are “closed-end”, meaning they have a finite life over which commitments from LPs are drawn down as investments are made. Common fund terms include a 10-year fund life with potential extensions.

Must See: The Ultimate Guide to Investing in Private Equity

Sourcing and Identifying Opportunities

With committed capital in place, the deal team at the PE firm searches for potential investment targets that fit their strategy and criteria. Proprietary deal flow is critical, and opportunities can originate from:

• Industry research and market screening
• Investment banking relationships
• Proprietary relationships and networks
• In-bound inquiries from companies seeking investments

Due Diligence and Deal Structuring

Once an attractive target is identified, the PE firm conducts extensive due diligence to assess:

• Industry dynamics and growth prospects
• Competitive positioning and strengths/weaknesses
• Financial performance and forecasts
• Management team capabilities
• Legal, tax, regulatory, ESG considerations

If they proceed, the investment and legal teams structure the deal mechanics, valuation, financing package, and legal agreements.

Making the Investment

With due diligence completed and agreements in place, the PE firm moves to complete the investment and capitalize the target company. This typically involves:

• Arranging debt financing from lenders
• Negotiating the purchase of equity stake
• Closing the deal and funding the investment

The target company’s capital structure is re-levered with debt, and the PE firm uses its equity commitments alongside the debt to fully acquire or gain a controlling stake.

Portfolio Management and Value Creation

Once the deal is closed, the real work begins on executing the agreed-upon value creation plan. The PE firm works closely with the company’s management through:

• Recruiting additional executive talent
• Implementing operational improvements
• Pursuing growth opportunities
• Leveraging the PE firm’s resources and expertise

The PE owners provide strategic guidance, and governance oversight, and hold management accountable to execute their investment thesis.

Check Out: How Does Private Equity Work? A Comprehensive Guide

Exiting the Investment

The ultimate goal is for the PE firm to eventually exit its investment at a higher valuation to generate the targeted returns for investors. Exits typically occur 4-7 years into the investment through:

• Initial public offering (IPO)
• Sale to another private equity firm
• Sale to a strategic corporate buyer
• Recap or refinancing to return capital

A successful exit allows the PE firm to return invested capital plus any profits back to the limited partners who committed to the fund.

Key Players in Private Equity

These are some key payers you need to know about in Private Equity

General Partners (GPs)

The general partner is the private equity firm itself that serves as the manager of a particular investment fund. Well-known PE firms include:

• Blackstone Group
• KKR
• Carlyle Group
• Apollo Global Management
• TPG Capital

The partners at the GP are responsible for deploying the committed capital into investments, managing those assets, and ultimately exiting them profitably.

Limited Partners (LPs)

Limited partners are the investors who commit capital to a PE fund managed by the general partners. LPs are “limited” in that they have no input over investment decisions. Common types include:

• Public and private pension funds
• Sovereign wealth funds
• Endowments and foundations
• Insurance companies
• Family offices and private wealth
• Fund of funds

Investment Managers and Advisers

Beyond the general partners, large PE firms employ teams of investment professionals to conduct diligence, execute deals, and create value across their portfolio companies, including:

• Investment banking advisers
• Strategy and operations consultants
• Legal counsel and compliance
• Tax and structuring specialists
• Investor relations and fundraising

Advantages and Risks of Private Equity

The Advantages and Risks of Private Equity are listed as follows:

Benefits for Investors

• Higher Potential Returns: Private equity targets returns well above public markets due to their ability to apply operationally focused value creation strategies. Top quartile funds can achieve 20%+ net IRRs.
• Diversification: Private equity allows investors to gain exposure outside of traditional public equities and fixed income. This diversifying asset class can help improve portfolio efficiency.
• Income and Cash Flows: PE funds generate ongoing income streams from portfolio company operations as well as capital returns upon successful exits.
• Alignment of Interests: The management fee and carried interest incentive structures help align the PE firm’s interests with those of their investors.
• Governance and Influence: As controlling investors, PE firms have influential governance rights and can implement operational and management changes.

Risks and Challenges

• Illiquidity: PE investments are illiquid with capital committed for 10+ years until assets are exited. There is no secondary market for trading.
• Loss of Capital: PE investments are high risk, and funds can generate low or negative returns if their companies do not perform as expected.
• Leverage Risks: The use of debt financing to maximize returns also amplifies the potential for losses.
• Manager Selection: Returns vary significantly between top-performing funds and the broader average. Picking skilled managers is critical for investors.
• High Fees: The fee structure of private equity is notoriously high compared to other asset classes. In addition to annual management fees of around 2%, PE firms also take around 20% of any profits generated as carried interest or performance fees. These lofty fees can eat into investor returns, especially for underperforming funds.
• Conflicts of Interest: There are potential conflicts between the interests of PE fund managers versus their investors. For example, GPs may be incentivized to employ higher leverage or risks to boost returns and earn higher fees.
• Lack of Transparency: Private equity investing involves less regulation and public disclosure requirements compared to public markets. This can lead to concerns around transparency for investors into fund operations, valuations, and performance reporting.
• Macroeconomic Risks: As with any investments, private equity returns are influenced by overall economic cycles, credit conditions, and market volatility. Funds may struggle to profitably exit during downturns.
• Concentration Risk: Many PE funds concentrate their holdings into a relatively small number of companies within certain sectors or geographies, amplifying any specific idiosyncratic risks.

While private equity offers compelling potential returns and portfolio diversification benefits, investors must weigh these risks carefully. Proper due diligence on fund managers, structures, and terms is essential before committing capital.

Funding and Capital Structures

To get a clearer view of the funding structures see the below:

Equity Capital

The private equity model starts with raising equity capital commitments from limited partner investors into a fund vehicle. Typical PE fund equity sizes can range from several hundred million up to $10 billion or more for larger funds.

This equity capital is then used by the GP to finance the equity portion of investments into portfolio companies. The equity stake allows the PE firm to gain influence via majority ownership and board seats.

Debt Financing

To boost investment returns, PE firms employ leveraged buyout (LBO) strategies where debt financing is utilized to maximize the equity portion’s potential upside. Common debt sources include:

• Senior secured loans from banks
• High-yield bonds
• Mezzanine debt
• Asset-backed lending

The acquired company’s cashflows are used to service this new debt over the investment period. Higher leverage does increase potential risks.

Mezzanine Financing

In addition to plain debt, mezzanine financing is another layer of capital that can be used. Mezzanine refers to subordinated debt or preferred equity that has aspects of both debt and equity.

Mezzanine providers accept higher risk than secured lenders in exchange for higher returns through cash interest payments and equity participation rights.

The strategic use of leverage and multi-layered capital structures allows PE firms to boost their equity returns while reducing the amount of invested capital required from their fund.

Popular Private Equity Strategies

Leveraged Buyouts (LBOs)

The quintessential private equity strategy centers around leveraged buyouts of established private or public companies. Key characteristics:

• Taking a controlling equity stake using significant debt financing
• Focusing on mature businesses with strong, stable cash flows
• Implementing operational and growth initiatives
• Holding for 3-7 year investment period
• Exiting via sale or IPO to monetize returns

Major LBO firms include KKR, Blackstone, Carlyle, and Apollo.

Growth Equity

Rather than outright buyouts, growth equity involves providing growth capital minority investments into companies looking to scale operations. Key points:

• Taking non-controlling equity stakes of 10-40%
• Targeting more mature, high-growth companies
• Focused on driving expansion, not turnarounds
• Investing equity to fund growth initiatives
• Potential to exit via future IPO or sale

Prominent growth equity investors include General Atlantic, Summit Partners, and TA Associates.

Distressed Investments

Alternatively, other PE funds take a distressed investment approach focused on troubled companies or assets that are undervalued. This strategy includes:

• Targeting companies facing operational or financial difficulties
• Looking for businesses with sustainable core operations
• Investing to provide rescue financing or restructuring
• Implementing operational turnarounds and deleveraging
• Exiting once the performance is stabilized and value is realized

Top distressed investors include Oaktree, Cerberus, and Apollo.

Special Situations and Turnarounds

Special situations is a catchall term for opportunistic investment strategies beyond plain distressed situations, such as:

• Corporate carveouts or orphan divisions being sold
• Operational or balance sheet restructurings and reorganizations
• Turnarounds of underperforming or mismanaged companies
• Contingency investing around major events like litigation or regulation

PE firms like Cerberus, HIG Capital, and Sun Capital specialize in these situations.

Industry/Sector-Focused Strategies

Many PE firms take a sector-focused approach, concentrating their investments within particular industries they have expertise in, such as:

• Healthcare (EVG, Bain Capital Life Sciences)
• Technology (Vista, Thoma Bravo)
• Consumer/Retail (Ares, Roark)
• Energy (Riverstone, EnCap)
• Real Estate (Blackstone RE, Colony)

The focus allows teams to better identify opportunities and apply their specialized industry knowledge to create value.

While strategies vary considerably, the core theme of private equity is applying operational and financial expertise to realize value from corporate underperformance or market inefficiencies.

How to Measure Performance

Given the long-term, illiquid nature of PE investments, standard public market metrics like time-weighted rates of return or Sharpe ratios are not sufficient for measuring performance. Some key PE metrics include:

Internal Rate of Return (IRR)

IRR is the most widely used PE performance metric, calculating the annualized effective compounded rate of returns generated over the life of an investment or fund. It analyzes the present value of all cash inflows against outflows.

Strong performing PE funds target generating net IRRs of over 20%, far exceeding public equity market returns of 6-8% annually.

Multiple on Invested Capital (MOIC)

Another simple metric is the multiple of invested capital, calculated as the total value generated from an investment divided by the initial cost basis. This represents the cash-on-cash return multiple.

For example, a MOIC of 3.0x means the investment tripled the value of the capital deployed. PE funds strive for MOICs in excess of 3x, though lower capital-efficient buyouts may target 2x or higher.

Public Market Equivalent (PME)

The public market equivalent calculates the return that would have been generated had the same capital invested in PE instead been invested in the public markets over the same holding period. This helps contextualize PE returns versus relevant public benchmarks.

Total Value to Paid-In (TVPI)

The total value to paid-in capital (investment) ratio measures the fund’s cumulative distributions back to investors against the paid-in capital drawn from investors. A TVPI of 1.5x means investors have received back 1.5x their original investment amount so far.

These metrics alongside internal rate of return and cash-on-cash multiples help LPs evaluate PE fund performance across dimensions like risk-adjusted returns, public market comparisons, and realized profits generated.

Regulation and Compliance

While often viewed as less regulated than public markets, the private equity industry still must adhere to various rules and compliance requirements, especially around fundraising activities.

Securities Laws and Registration

In most countries, the offer and sale of securities in private equity funds must be registered or qualify for available exemptions. The major regulations include:

• U.S.: Securities Act of 1933 and Investment Company Act
• EU: Alternative Investment Fund Managers Directive (AIFMD)
• Other country-specific securities laws and safe harbors

PE fund advisers with over $150M in assets must register as investment advisors, putting them under further regulatory oversight.

Fiduciary Responsibilities

PE fund managers operate under a fiduciary duty to their investors, meaning they must make decisions based on good faith and avoid conflicts of interest. Duties include:

• Loyalty – Acting in the best interests of investors
• Care – Applying adequate oversight and prudence
• Candor – Providing full disclosure of material information
• Compliance – Conforming to fund agreements and policies

Breaches of these duties can expose PE firms to legal liabilities.

Anti-Corruption Measures

Given PE firms’ international operations and capital commitments from public pensions/entities, they must demonstrate robust anti-money laundering and anti-corruption practices.

Key laws include the U.S. Foreign Corrupt Practices Act (FCPA), UK Bribery Act, and local regulations in countries they invest in. Sufficient due diligence and internal controls are required.

Tax and Reporting Requirements

Violations of tax laws or inadequate reporting can expose PE firms to significant penalties from regulators in addition to reputational damage.

In recent years, there has been increased pressure and scrutiny around the tax practices employed by private equity firms. The tax advantages and structures utilized by the industry have come under criticism from government authorities and public interest groups for being too aggressive or lacking transparency.

For example, the taxation of carried interest at preferable capital gains rates rather than ordinary income tax rates has been a contentious issue. Several countries have either closed these loopholes or are re-evaluating the tax treatment of fund compensation.

Additionally, as part of global tax reform efforts like the OECD’s Base Erosion and Profit Shifting (BEPS) project, there is a push for greater tax transparency and information-sharing requirements between jurisdictions. This aims to crack down on tax avoidance strategies that shift profits to low-tax jurisdictions.

To mitigate risks, PE firms must stay compliant with evolving tax regimes across the multitude of countries they operate and invest in. This requires experienced tax advisors and robust reporting systems to properly account for their global activities and structures.

Ultimately, institutional investors are demanding more tax transparency and responsible practices from the private equity funds they commit capital to. PE firms that fail to keep up with tax obligations and disclosures may face difficulties raising future funds.

Getting Into Private Equity

Given the potential for achieving higher returns, many investors seek exposure to the private equity asset class. However, there are various hurdles and requirements involved in gaining access.

Typical Career Paths

For professionals looking to work at top-tier PE firms, relevant experience from investment banking, management consulting, corporate development, or operational roles is typical.

Common paths include:

• Investment banking analysts/associates
• Management/strategy consulting
• Corporate finance/development
• Professional services (accounting, law)
• Operating roles at portfolio companies
• Moving over from other investing roles (HF, VC, etc.)

Relevant deal experience, financial modeling, strategic advisory, and an understanding of business operations are highly valued skill sets.

Skills and Qualifications

Beyond experience from a credentialed firm, PE firms prize certain core competencies when hiring analysts and associates, such as:

• Outstanding analytical abilities
• Financial modeling and MS Excel skills
• Knowledge of valuation, M&A, financing
• Attention to detail and strong work ethic
• Ability to work in teams under tight deadlines
• Excellent written and verbal communication
• Quantitative and creative problem-solving skills

Top academic pedigrees from target schools is also an advantage, though exceptional performance and expertise can outweigh this factor.

Entry-Level Roles

Candidates often start out in the following entry-level roles at PE firms before potentially advancing to senior associate, VP, principal, and partner positions:

• Analyst: Typically entry-level post-graduates
• Associate: 2-4 years of relevant deal experience
• Senior Associate: 4+ years of relevant experience

Analysts and associates work as part of deal teams conducting investment research, due diligence, analyzing potential acquisitions, and monitoring portfolio companies.

Given the intense competition to break into the elite PE firms, candidates often have to gain experience at smaller funds or in related fields before earning an opportunity at the largest players.

The Future of Private Equity

The private equity industry has undergone immense growth over the past few decades, expanding across sectors, strategies, and geographies. However, the industry continues to evolve amid broader economic and technological forces.

Impact of Technology and Disruption

Much like the companies PE firms invest in, the industry itself faces digital disruption and innovation. Key technology trends impacting private equity include:

• Data and Analytics: Firms are increasingly utilizing big data, AI/ML, and advanced analytics to drive better investment decisions, portfolio monitoring, and value-creation initiatives. This allows them to process more data points and synthesize insights faster.
• Digital Operations and Processes: There is growing digitization across key investment processes like fundraising, diligence, deal-making, and portfolio management. PropTech, dealTech, and regulatory compliance software can create efficiencies.
• Cybersecurity: With more sensitive data stored digitally, cybersecurity resilience has become a critical focus area to safeguard assets and data integrity.
• Disruptive Innovation: PE must adapt to disruptive forces impacting their portfolio companies’ business models across sectors like fintech, e-commerce, autonomous vehicles, and more.

Firms that embrace and adopt the latest technologies stand to gain a competitive edge in everything from sourcing deals to driving operational value creation.

ESG and Sustainable Investing

Another major focus centers around integrating environmental, social, and governance (ESG) principles more firmly into investment strategies. As more LPs incorporate sustainable investing mandates, PE firms must adapt in several ways:

• Conducting ESG due diligence pre-acquisition
• Monitoring and managing ESG risks across the portfolio
• Implementing ESG value creation and impact initiatives
• Measuring and reporting on ESG metrics and outcomes
• Aligning fundraising and marketing around ESG/impact

According to EY, 92% of PE firms now consider the ESG approach of portfolio companies in their due diligence. Embedding robust, credible ESG practices is becoming a critical competitive differentiator.

Opportunities in Emerging Markets

While established PE markets in the U.S. and Europe are maturing, emerging economies like Asia, Latin America, and Africa represent exciting new frontiers for private equity deployment. Key drivers include:

• Rising middle-class consumer populations
• Secular demographic shifts and urbanization trends
• Need for infrastructure development and financing
• Corporate restructuring and privatization opportunities
• Potential for operational improvements and value creation

Risks like political instability, regulatory hurdles, and underdeveloped capital markets remain. However, many leading global PE firms continue to expand their presence and capital allocations to these high-growth emerging regions.

Looking ahead, the private equity industry will be shaped by its ability to continually innovate, create value, incorporate sustainable investing practices, and capitalize on opportunities across both developed and emerging markets worldwide.

Private Equity FAQ

What is a private equity investment?

Private equity refers to investment firms that acquire stakes in private companies or take public companies private, with the goal of using operational and financial expertise to improve and grow the business before eventually exiting the investment for a profit.

How do private equity firms generate returns?

PE firms pool capital from investors (limited partners) into funds, which are used to acquire controlling stakes in companies, often using debt financing to maximize returns. They then work to improve operations and position the company for an eventual exit via IPO or sale, earning returns on the equity investment.

What are the key differences between private equity and venture capital investments?

While both involve investing equity into private companies, venture capital focuses specifically on funding early-stage, high-growth startups. Private equity takes a broader approach, targeting investments across different stages from VC-backed startups to mature companies and leveraged buyouts.

What are the typical investment stages of private equity firms?

The core stages include 1) Fundraising capital commitments from limited partners, 2) Sourcing and evaluating investment opportunities, 3) Conducting due diligence and deal execution, 4) Actively managing the acquired portfolio company and implementing value creation plans, and 5) Ultimately exiting investments to return capital plus profits.

What are general partners and limited partners in a private equity fund?

General partners are the private equity firm itself that manages the investment activities of a particular fund. Limited partners are the investors that commit capital to the fund but have no active investment decision-making role beyond monitoring and oversight.

What are the main risks associated with private equity investments?

Key risks include illiquidity of capital over the fund’s lifetime, loss of capital and high leverage risks if investments underperform, uncertainties around manager skill and selection, high fees, transparency concerns, and macroeconomic/market risks impacting exit environments.

This comprehensive guide covered the fundamentals of how private equity works – the investment strategies, deal process, funding models, players involved, performance measurement, regulations, careers, and future trends shaping the industry. While highly lucrative when executed successfully, PE investing also carries substantial risks that investors must weigh carefully.

Hopefully, this guide has provided a solid base of knowledge for understanding the private equity asset class as a beginner.