Private equity (PE) has grown into one of the largest asset classes in the world. As of 2023, private equity managers oversaw more than $13.1 trillion in assets, according to McKinsey¹. Despite its size and influence, private equity remains unfamiliar to many investors.

In this post, we explain how private equity funds are structured, how they generate returns, and what risks investors should understand before committing capital. Future posts in this series will explore specific strategies in greater detail.

What Is Private Equity?

Private equity refers to investments in companies that are not traded on public stock exchanges. These companies may be startups, growth-stage firms, or mature businesses undergoing transitions.

Investments are typically made through limited partnerships. The investment firm serves as the general partner (GP) and manages the fund, while investors act as limited partners (LPs). LPs contribute capital but are not involved in daily operations or decision-making. Their liability is limited to the capital they have committed.

Fund Structure and Lifecycle

Most private equity funds are closed-end vehicles with a defined lifespan, typically 10 to 12 years. Each fund has a vintage year, which marks the beginning of the investment period. For example, a 2026 vintage fund may be scheduled to conclude by 2036.

In the first three years, the GP issues capital calls, drawing on committed capital as investment opportunities arise. Once capital is deployed, the GP works to grow the companies in the portfolio and pursue exit opportunities such as sales or public offerings.

The proceeds from these exits are distributed to the LPs, net of management and performance fees.

The J-Curve Effect

Private equity returns tend to follow a pattern known as the J-Curve. Early in the fund’s life, performance often appears negative. This is due to capital being deployed and fees being charged before any gains are realized.

As investments mature and begin to generate returns, performance improves. Successful funds show a steep upward curve during the later years of the fund, resulting in a shape that resembles the letter “J.”

Understanding this pattern is essential. Investors should not expect immediate gains and must be prepared for early underperformance.

Illiquidity and Transparency

Private equity investments are illiquid. Once you commit capital, it is generally locked in until the fund reaches the end of its life. Early withdrawals are not allowed or come with significant penalties.

Valuations are also less transparent than in public markets. Fund managers may provide quarterly updates, but these rely on internal models or periodic third-party appraisals. Because valuations are infrequent, returns may appear smoother than they truly are. This can mask the underlying volatility of the investments.

Measuring Returns

Performance is typically measured using internal rate of return (IRR). IRR accounts for the timing and amount of cash flows throughout the life of the fund. This makes it more accurate for evaluating long-term investments with irregular distributions.

However, since full performance cannot be assessed until all investments are exited and proceeds distributed, evaluating a fund’s success requires patience.

Fee Structure

Private equity managers are compensated through both management fees and performance fees:

• Management fees are typically 1% to 2% of committed capital charged annually.
• Performance fees (or carried interest) are usually 10% to 20% of any profits generated above a certain threshold.

These fees can significantly impact net returns, which makes understanding the fee structure critical before investing.

Who Can Invest?

Due to regulatory requirements and high minimums, private equity is often limited to institutional and ultra-high-net-worth investors. Minimum investments typically range from $250,000 to $1 million.

Investors must also meet other criteria and demonstrate the ability to bear the risks associated with illiquidity, limited transparency, and long holding periods.

What Comes Next

This post covers the foundational structure of private equity funds. In future posts, we will explore the primary private equity strategies, including:

• Leveraged buyouts
• Venture capital and mezzanine debt
• Private real estate
• Timberland and farmland

Private equity offers compelling long-term potential, but only for those who understand the structure, risks, and return profile. As with all investment decisions, alignment with your long-term goals is essential.

Have questions about private equity and how it may fit into your financial strategy? Contact your Empirical advisor to start a conversation.

^[1] https://www.mckinsey.com/industries/private-capital/our-insights/mckinseys-private-markets-annual-review

*See Disclosures