Private equity explained: strategies, fund structure, fees and what research shows about returns

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Private equity is equity capital for companies that are not listed on a stock exchange. It usually flows through funds that raise money from pension funds, foundations, insurers and, increasingly, retail investors, then buy companies, develop them and sell them after a few years. This article explains strategies, fund structure and fees, works through a distribution waterfall with carried interest, and summarises what research knows about returns, dispersion and risks.

What private equity is

In the narrower sense, private equity means buyouts: in a leveraged buyout, according to Kaplan and Strömberg (2009), a specialised investment firm buys a company with little equity and a lot of debt; these firms now call themselves private equity firms. In the broader sense, growth financing and venture capital are also included. What they all have in common: there is no market price, the stake is held for years, and a large part of the return only arises on exit.

Strategies at a glance

Loans to companies in the private equity space are not private equity but private credit or private debt. Funds open to retail investors are described in the article ELTIF and in the glossary under semi-liquid fund.

Fund structure: GP, LP and term

A classic private equity fund is a limited partnership: the manager (general partner, GP) decides on purchases and sales, while the investors (limited partners, LPs) make a capital commitment and are liable only up to their contribution. According to Kaplan and Strömberg (2009), a fund usually runs for ten years, extendable by up to three years. In the first years, the fund calls capital and invests; after that, it sells the holdings and distributes the proceeds. What this means for cash flows, the J-curve and metrics such as TVPI and IRR is worked through in the article measuring private markets.

Because the money is only called gradually, a fund is never fully invested, and you must be able to pay the outstanding commitment at any time. If you fail to meet a capital call, you are in default. The consequences are set out in the fund agreement. Before the end of the term, you can only sell on the secondary market, at a price that may differ from the NAV.

Fees: management fee, carried interest and hurdle

• Management fee: according to Kaplan and Strömberg (2009), a percentage initially of committed capital and later often of invested capital. At 2% on a commitment of 100, that would be 10 over a five-year investment period, regardless of performance.
• Carried interest: the manager's share of profits, according to Kaplan and Strömberg (2009) almost always 20% of the profits.
• Hurdle rate: the preferred return for investors before the carry kicks in; 8% a year in the example below. With a catch-up, the manager then catches up until it has its 20% of the total profit.
• Waterfall: the order of distribution. In the European model (whole fund), investors first get back all their capital plus the preferred return; in the American model (deal by deal), each holding is settled separately, with a clawback if later losses make the carry retrospectively too high.

How much the fees add up to in total is disputed. Metrick and Yasuda (2010) analysed the agreements of 238 funds: about two thirds of managers' expected revenue comes from fixed components that do not depend on performance. Phalippou and Gottschalg (2009) estimate the fees at 6% a year, and according to Phalippou (2009), the agreements are opaque and hide costly clauses in the details. Unlike the performance fee of a hedge fund with a high-water mark, the carry depends on realised profits over the entire term.

Worked example: the waterfall

What research shows about returns

• Kaplan and Schoar (2005): after fees, private equity funds on average achieved roughly the return of the S&P 500, with large differences between funds.
• Harris et al. (2014): using cash flow data from almost 1,400 US funds, buyout funds outperformed the S&P 500 by 20 to 27% over their life, more than 3% a year; venture capital outperformed in the 1990s and underperformed in the 2000s.
• Phalippou and Gottschalg (2009): industry figures overstate returns, partly because of inflated valuations of ongoing holdings. After fees, the funds were 3% a year below the S&P 500, and 6% on a risk-adjusted basis.
• Phalippou (2020): since at least 2006, private equity funds have delivered roughly the return of equity indices; three large datasets show average net multiples of 1.55, 1.57 and 1.63 times capital, which corresponds to about 11% a year. At the same time, an estimated $230 billion in carry was earned.
• Franzoni et al. (2012): private equity carries the same liquidity risk as equities; the premium for it is about 3% a year, and once it is accounted for, the alpha in the four-factor model disappears.
• Ilmanen et al. (2020): a leveraged small-cap index is a better benchmark than large-cap stocks; the estimated edge of private equity over equities has declined over time, yet demand has risen.

So the benchmark matters a great deal: against the S&P 500, buyout funds look good; against leveraged small value stocks, the edge shrinks or disappears (Phalippou 2014; L’Her et al. 2016). How to compare correctly (with a public market equivalent instead of IRR against an index return) is shown in measuring private markets.

Dispersion and persistence of managers

There are large differences between funds. Kaplan and Schoar (2005) also found, unlike for mutual funds, strong persistence of a manager's results across its successor funds. Using more recent data, Harris et al. (2023) show that this still holds for venture capital, but has weakened considerably for buyout funds. What matters is what investors know when they commit: using the interim results of the predecessor fund at the time of fundraising, the authors find hardly any persistence for buyouts, especially after 2000. Interim results are only moderately related to final results, and managers avoid raising money when their interim results are weak.

Access for retail investors

• Listed private equity companies and ETFs on them: tradable daily, but subject to stock market fluctuations. According to Jegadeesh et al. (2015), they have a beta close to one and more systematic risk than an index built from reported NAVs; the market expected an excess return of between −0.5% and 2% a year for unlisted funds.
• ELTIFs: EU funds for long-term investments; since the reform (Regulation (EU) 2023/606 2023), there is no statutory minimum investment for retail investors, but a suitability assessment is required. Redemptions, where offered at all, are limited according to the standards of Delegated Regulation (EU) 2024/2759 (2024).
• Evergreen and semi-liquid funds: invest on an ongoing basis and redeem units to a limited extent on fixed dates; the price is the estimated NAV, not a market price.
• Feeder funds and funds of funds: pool smaller amounts for classic funds, with an additional layer of fees.

This overview is not a recommendation for any structure or fund. What matters for the comparison are fees at all levels, redemption rules, valuation methods and leverage at fund level.

Risks

• Illiquidity: capital is tied up for ten years or longer; a sale on the secondary market can cost a discount, in 2022 according to Saccone (2024) an average of 19% to NAV.
• Valuation smoothing: estimated NAVs make volatility and correlation look too small (return smoothing).
• Leverage: in the companies and increasingly at fund level, for example via subscription lines and NAV financing, which according to ILPA (2024) should count as fund-level leverage.
• Fees and conflicts of interest: two layers of fees in funds of funds; in continuation funds, according to ILPA (2023), the manager is on both sides of the transaction.
• Capital call risk: calls come when the fund buys. That can also be during crises, when the rest of your wealth has fallen.
• Dispersion: a single fund can perform considerably worse than the average; a small number of funds means concentration risk.

For advanced readers: what fees and metrics conceal

• Gross and net: in the example above, the carry alone pushes the return down from 14.87% to 12.47%; management fees come on top and show up in the J-curve, because they are incurred early.
• Fixed revenue: according to Metrick and Yasuda (2010), successful buyout managers grow mainly through larger successor funds. The business scales better than venture capital, which considerably increases revenue per partner.
• Metrics with leeway: credit lines boost the IRR (ILPA 2017), and NAV financing brings distributions, and with them the DPI, forward (ILPA 2024).
• Multiples instead of IRR: Phalippou (2020) argues using multiples and PME, because IRRs can be distorted by early successes and the timing of cash flows.

Limitations and common mistakes

• Comparing IRR with an index return: money-weighted against time-weighted; PME methods make for a fair comparison.
• Top-quartile claims: whether a fund is in the top quartile depends on the peer group, the cut-off date and the metric. And according to Harris et al. (2023), interim results say only moderately much about the final result.
• The wrong benchmark: an unlevered large-cap index makes buyouts look better than they are on a risk-adjusted basis.
• Feeding smoothed volatility into the optimisation: private equity then gets too much weight.
• Overestimating liquidity: semi-liquid funds can limit redemptions, precisely when many investors want to sell.

How Portfolio Lab calculates it

Portfolio Lab cannot model fund investments with capital calls and distributions. For private equity, Asset classes offers the series Listed private equity: listed private equity companies, via an ETF from 2007 and a US ETF before that, converted into euros. It fluctuates with the stock market and is not smoothed. If you would rather replicate the risks of buyouts, you can apply leverage to Equities US small cap value in the Backtest. This is a rough public proxy, not a replica of a fund. The app does not calculate fees, carried interest or the J-curve. More in the asset classes methodology.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.