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Private equity is ownership or interest in an entity that is not publicly listed or traded. A source of investment capital, private equity comes from high-net-worth individuals and firms that purchase stakes in private companies or acquire control of public companies with plans to take them private, eventually delisting them from stock exchanges. The private equity industry is comprised of institutional investors such as pension funds, and large private equity firms funded by accredited investors.

Because private equity entails direct investment—often to gain influence or control over a company's operations—a significant capital outlay is required, which is why funds with deep pockets dominate the industry. The minimum amount of capital required for accredited investors can vary depending on the firm and fund. Some funds have a $250,000 minimum entry requirement, while others can require millions more.

The underlying motivation for such commitments is the pursuit of achieving a positive return on investment (ROI). Partners at private-equity firms raise funds and manage these monies to yield favorable returns for shareholders, typically with an investment horizon of between four and seven years.

The Private Equity Profession

The private equity business attracts the best and brightest in corporate America, including top performers from Fortune 500 companies and elite management consulting firms. Law firms can also be recruiting grounds for private equity hires, as accounting and legal skills necessary to complete deals and transactions are highly sought after.

The fee structure for private-equity firms varies but typically consists of a management and performance fee. A yearly management fee of 2% of assets and 20% of gross profits upon sale of the company is common, though incentive structures can vary considerably.2

Given that a private-equity firm with $1 billion of assets under management (AUM) might have no more than two dozen investment professionals, and that 20% of gross profits can generate tens of millions of dollars in fees, it is easy to see why the industry attracts top talent. At the middle market level—$50 million to $500 million in deal value—associates can earn low six figures in salary and bonuses, while vice presidents can earn approximately half a million dollars. Principals, on the other hand, can earn more than $1 million in (realized and unrealized) compensation per year.

Types of Private-Equity Firms

Private-equity firms have a range of investment preferences. Some are strict financiers or passive investors wholly dependent on management to grow the company and generate returns. Because sellers typically see this as a commoditized approach, other private-equity firms consider themselves active investors. That is, they provide operational support to management to help build and grow a better company.

Active private equity firms may have an extensive contact list and C-level relationships, such as CEOs and CFOs within a given industry, which can help increase revenue. They may also be experts in realizing operational efficiencies and synergies. If an investor can bring in something special to a deal that will enhance the company's value over time, they are more likely to be viewed favorably by sellers.

Investment banks compete with private-equity firms (also known as private equity funds) to buy good companies and to finance nascent ones. It is no surprise that the largest investment-banking entities such as Goldman Sachs (GS), JPMorgan Chase (JPM) and Citigroup (C) often facilitate the largest deals.

In the case of private-equity firms, the funds they offer are only accessible to accredited investors and may only allow a limited number of investors, while the fund's founders will often take a rather large stake in the firm as well. However, some of the largest and most prestigious private equity funds trade their shares publicly. For instance, the Blackstone Group (BX) trades on the New York Stock Exchange (NYSE) and has been involved in the buyouts of companies such as Hilton Hotels and MagicLab.34

How Private Equity Creates Value

Private-equity firms perform two critical functions:

deal origination/transaction execution

portfolio oversight

Deal origination involves creating, maintaining and developing relationships with mergers and acquisitions (M&A) intermediaries, investment banks, and similar transaction professionals to secure both high-quantity and high-quality deal flow. Deal flow refers to prospective acquisition candidates referred to private-equity professionals for investment review. Some firms hire internal staff to proactively identify and reach out to company owners to generate transaction leads. In a competitive M&A landscape, sourcing proprietary deals can help ensure that funds raised are successfully deployed and invested.

Additionally, internal sourcing efforts can reduce transaction-related costs by cutting out the investment banking middleman's.