How Private Equity Gets Rich Buying Companies With Other People’s Money

Private equity is often described as a business of buying struggling companies, improving their operations and selling them for a profit. That description is accurate in the same way that saying a casino accepts wagers is accurate: It explains the basic transaction without revealing where the real economic advantages are concentrated.

A private equity firm does not ordinarily use only its founders’ money to purchase a company. It raises a fund from pension plans, endowments, insurance companies, family offices and wealthy investors, then supplements that capital with debt placed largely on the company being acquired. The firm manages the investment, collects fees throughout the process and may receive a substantial share of the profits if the deal succeeds. If the company later struggles under the debt, the workers, creditors and outside investors can absorb much of the damage while the private equity manager may already have collected years of management fees.

This structure does not make every private equity transaction destructive. Some firms provide capital, professional management and strategic discipline that help businesses expand, modernize or survive a difficult transition. Others create returns through aggressive cost reductions, financial engineering and debt-funded payments that can leave the acquired company weaker than it was before. Understanding private equity requires examining both possibilities and recognizing that the incentives do not always align with the long-term health of the company being purchased.

Private Equity Begins With a Fund, Not a Company Purchase

A private equity firm typically creates a separate investment fund rather than placing every acquisition directly on its own balance sheet. Many funds are structured as limited partnerships, often in Delaware, with a general partner controlling investment decisions and limited partners supplying most of the capital. The Securities and Exchange Commission notes that a limited partnership agreement establishes the fund’s central terms, including capital commitments, management fees, profit allocation, withdrawal restrictions and the authority granted to the general partner.

The limited partners may include public pension systems, university endowments, charitable foundations, insurance companies and wealthy individuals. They commit a stated amount to the fund but do not necessarily transfer all the money on the first day. The private equity manager issues capital calls as acquisitions and fund expenses arise, requiring investors to provide their agreed share within the deadlines established by the partnership agreement.

The general partner or an affiliated management company identifies potential investments, arranges financing, supervises the portfolio companies and eventually decides when to sell. Limited partners receive economic exposure but ordinarily have far less control over individual transactions. That concentration of authority is intentional because the fund is marketed on the manager’s ability to select and manage investments without requiring a vote from every investor each time a deal appears.

Private funds generally raise money through exemptions from the public securities-registration system. A traditional fund relying on Section 3(c)(1) of the Investment Company Act may have no more than 100 beneficial owners, while funds relying on Section 3(c)(7) are generally limited to qualified purchasers and may accommodate a larger investor base. Private offerings frequently rely on Regulation D, and the eligibility of accredited investors or qualified purchasers can determine who is permitted to participate.

The Famous “Two and Twenty” Model Is Only the Starting Point

Private equity compensation is commonly summarized as “two and twenty”: an annual management fee of approximately 2% and a performance allocation of roughly 20% of investment profits. Actual agreements vary, but the formula explains why raising a large fund can be highly lucrative even before the investments are sold.

The management fee is generally calculated on committed capital during the investment period and may later shift to invested capital, remaining portfolio value or another base established in the partnership agreement. The SEC describes private equity management fees as charges commonly based on a percentage of capital committed to or invested in the fund, in addition to performance compensation.

A firm managing a $1 billion fund at a 2% annual rate could collect approximately $20 million a year before paying salaries, offices, compliance costs and other operating expenses. The fee may decline later in the fund’s life, but it can continue for many years because private equity funds commonly have terms of roughly a decade, often with extension options. This creates a stable revenue stream that rewards the firm for increasing assets under management, regardless of whether every acquisition ultimately succeeds.

The performance allocation, usually called carried interest, gives the general partner a share of profits after investors receive the return specified in the agreement. Many funds include a hurdle or preferred return that must be achieved before the manager becomes entitled to carry, along with a “catch-up” mechanism that determines how subsequent profits are divided. SEC filings from major private equity firms show that a 20% allocation of net realized gains has long been a common arrangement, although the exact percentage and calculation can differ among funds.

The fund documents may also address transaction fees, monitoring fees, consulting charges and expenses paid by portfolio companies. Some of those amounts may offset management fees owed by investors, while others can provide additional revenue to the private equity firm or its affiliates. The final economics therefore depend on far more than the simple two-and-twenty slogan.

Carried Interest Receives Favorable Tax Treatment Under Certain Conditions

Carried interest is controversial because part of a private equity manager’s compensation may be taxed as long-term capital gain rather than as ordinary wage income. The maximum federal rate on most long-term capital gains is generally lower than the top rate on ordinary income, although the 3.8% Net Investment Income Tax and state taxes may also apply.

Section 1061 of the tax code generally requires certain gains allocated through an applicable partnership interest to satisfy a holding period of more than three years to retain long-term capital-gain treatment. When the requirement is not met, the affected gain may be recharacterized as short-term capital gain and taxed at ordinary rates.

The favorable treatment is defended on the ground that carried interest rewards investment performance and exposes managers to entrepreneurial risk. Critics argue that it is compensation for providing investment-management services and should therefore be taxed more like a salary or bonus. The debate persists because the manager may receive a large share of gains despite contributing only a small fraction of the fund’s total capital.

A new private equity firm should not assume that every performance payment will automatically qualify for a 20% federal rate. Holding periods, partnership allocations, fund structure and the character of the underlying gains all matter. The tax treatment requires specialized legal and accounting advice rather than a generic provision copied from another fund’s documents.

The Leveraged Buyout Places Debt at the Center of the Deal

The defining transaction in corporate private equity is the leveraged buyout. The fund contributes equity, lenders provide a significant portion of the purchase price and the acquired company becomes responsible for servicing much of the resulting debt.

Suppose a fund purchases a company for $500 million using $200 million of investor equity and $300 million of borrowed money. If the company is later sold for $700 million after reducing the debt to $200 million, the equity value at exit would be approximately $500 million before fees and expenses. Turning $200 million of initial equity into $500 million produces a far stronger return than purchasing the company entirely with cash.

Leverage magnifies losses in the same way. If the company’s value falls, interest expenses rise or cash flow weakens, the debt remains. A business that once had a manageable balance sheet can become financially fragile because the acquisition was structured to maximize the buyer’s return on a smaller equity contribution.

The debt is frequently secured by the assets and cash flows of the acquired company rather than solely by the private equity firm. That distinction is central to the model. The fund controls the company and benefits from the upside, while the operating business must generate the cash required to repay the financing used to purchase it.

Higher interest rates make that structure more difficult because many leveraged loans carry floating rates. The Financial Times reported that 110 private equity- and venture-backed companies filed for bankruptcy in 2024 according to S&P Global Market Intelligence, with heavy debt and higher borrowing costs contributing to distress, although narrower measures of large private equity bankruptcies have produced less dramatic results.

The existence of bankruptcy risk does not prove that every leveraged buyout is reckless. It does demonstrate that private equity returns often depend on financing conditions that the portfolio company cannot control.

Buying the Company Is Only the Beginning

Before completing an acquisition, a private equity firm conducts due diligence on the target’s finances, customers, management, contracts, debt, taxes, technology, legal exposure and competitive position. The objective is not simply to determine whether the company is attractive. It is to identify what can be changed, how much debt the business can support and what a future buyer might be willing to pay.

The investment committee evaluates a financial model that usually includes revenue growth, profit margins, capital expenditures, debt repayment and several potential exit values. Small changes in those assumptions can dramatically alter the projected internal rate of return. A purchase that appears attractive at one valuation or financing rate may become far less compelling if earnings fall or the exit multiple declines.

Private equity managers often search for companies with predictable cash flow because lenders are more willing to finance businesses capable of servicing debt consistently. Recurring revenue, strong customer retention and limited capital needs can make a company attractive even when its growth is modest. Firms may also pursue fragmented industries in which several smaller businesses can be acquired and combined into a larger platform.

The firm’s reputation depends heavily on discipline during this stage. An acquisition price that assumes perfect execution leaves little room for mistakes, while aggressive debt can turn an ordinary business setback into a restructuring or bankruptcy. The best private equity managers earn returns partly by refusing deals whose numbers work only under optimistic assumptions.

Operational Improvement Is Real, but So Is Financial Engineering

Once a purchase is complete, the private equity firm typically installs a board, monitors financial performance and begins implementing its investment plan. The strategy may include new technology, improved pricing, geographic expansion, acquisitions of competitors or the recruitment of stronger executives. These changes can produce genuine productivity gains and build a company worth more than the one originally purchased.

Cost reduction is also common because eliminating waste improves profit margins quickly. The consequences depend on what is being cut. Consolidating duplicate accounting systems or renegotiating procurement contracts may strengthen the business, while reducing staffing, maintenance or customer service too aggressively can improve short-term earnings at the expense of long-term performance.

Private equity firms may also increase value through multiple expansion, meaning the company is sold at a higher valuation relative to earnings than the fund originally paid. That outcome can reflect a stronger, larger business, but it can also depend on favorable capital markets rather than operational improvement. A fund that buys a company for eight times earnings and sells it for 12 times earnings can generate a large return even when the underlying business has changed less dramatically than the headline profit suggests.

Another strategy involves acquiring a platform company and adding smaller competitors, often called a roll-up. The combined business may reduce overhead, gain bargaining power and attract a higher valuation because of its larger scale. Roll-ups can also become difficult to manage when systems, cultures and debt obligations accumulate faster than the operating company can integrate them.

Employees Experience Both the Gains and the Damage

Private equity is frequently accused of generating returns primarily through layoffs. The evidence is more complicated than either the industry’s supporters or critics often suggest.

Research summarized by the National Bureau of Economic Research found that private equity buyouts were associated with faster job destruction at target establishments but also faster job creation, particularly at newly opened locations. The combined result showed substantially greater employment reallocation than at comparable businesses, meaning private equity ownership accelerated both contraction and expansion rather than producing one universal employment outcome.

That distinction offers little comfort to a worker whose position is eliminated. A firm can create new jobs in one location while closing a longtime facility elsewhere, and the people displaced may not have access to the new opportunities. Cost reductions that appear efficient at the portfolio level can destabilize communities whose employment depended on the acquired business.

The effect also varies by transaction. A growth investment in a software company may add workers, while a buyout of a mature retailer may be built around store closures, real-estate sales and reduced payroll. Presenting every private equity acquisition as a job destroyer is inaccurate, but presenting layoffs as unrelated to the return model is equally misleading.

The Exit Determines Whether the Investment Worked

Private equity funds are not generally designed to own companies forever. They seek an exit that converts the investment into cash or marketable securities and allows gains to be distributed to investors.

One option is a sale to a strategic buyer, such as a larger company seeking the portfolio company’s customers, technology or market position. Another is a sale to a different private equity firm, sometimes called a secondary buyout. A sufficiently large company may be taken public through an initial public offering, although the fund may continue holding shares and sell them gradually after the listing.

The exit price depends on business performance, debt levels, market valuations and the availability of financing for the next buyer. A strong company can produce a disappointing investment if it was purchased too expensively, while a mediocre company can generate a successful fund return if leverage, debt repayment and market conditions work in the sponsor’s favor.

Private equity performance is often measured through internal rate of return and multiples of invested capital. Internal rate of return gives substantial weight to timing, so receiving cash quickly can improve the reported result even when the total profit is not exceptional. Investors must examine both measures, along with fees, remaining unrealized assets and the assumptions used to value companies that have not yet been sold.

Starting a Private Equity Firm Requires More Than Finding a Business to Buy

An aspiring private equity manager needs a legal structure, investment strategy, capital base, operating infrastructure and credible record of making or managing investments. Forming a Delaware limited partnership and creating a general partner may be relatively straightforward from a filing perspective, but raising outside capital turns the project into a regulated securities and investment-advisory business.

Private funds raise capital through exempt offerings, and advisers may need to register with the SEC or state regulators unless an exemption applies. The federal private-fund-adviser exemption generally applies to advisers that manage only private funds and have less than $150 million in private-fund assets under management in the United States, although exempt advisers may still have reporting and state obligations.

The firm also needs offering documents, subscription agreements, compliance policies, valuation procedures, investor reporting, cybersecurity controls and processes for managing conflicts of interest. Bank accounts, fund administration, audits, tax reporting and anti-money-laundering procedures must be addressed before institutional investors will take the operation seriously.

First-time managers often invest meaningful personal capital because investors expect the general partner to share the risk. The commitment demonstrates confidence but does not replace an investment record. Limited partners will examine how prior deals performed, whether returns came from operating improvement or leverage, how losses were handled and whether the team has experience sourcing, financing and managing companies.

Managers without an institutional record may begin with an independent sponsor model, raising capital one transaction at a time rather than establishing a blind-pool fund. This structure allows investors to evaluate each acquisition but creates uncertainty because the manager must secure financing after identifying the target. Others begin with a small fund backed by personal networks, family offices or executives familiar with the chosen industry.

A Narrow Strategy Is More Credible Than a Promise to Buy Anything

New firms often improve their fundraising prospects by specializing. A manager who has spent 20 years operating healthcare-service companies may be more credible buying regional medical businesses than presenting a broad strategy covering software, manufacturing, consumer products and real estate.

The fund documents should define the size, industry, geography and characteristics of acceptable investments. Investors want to know how opportunities will be sourced, what operational skills the team possesses and why the manager has an advantage over larger firms competing for the same businesses.

Specialization can also improve due diligence because the manager understands normal margins, regulatory risks, customer concentration and realistic growth rates. A generalist may see an apparently inexpensive company, while an industry specialist recognizes that its earnings depend on temporary pricing, one expiring contract or an approaching regulatory change.

The investment thesis must be specific enough to guide decisions without becoming so narrow that the fund cannot deploy capital. A strategy built around acquiring profitable founder-owned companies in one fragmented industry is more defensible than a promise to locate “undervalued opportunities” wherever they appear.

More Assets Create More Fees, but Not Necessarily Better Investments

The management-fee model gives private equity firms a strong incentive to raise progressively larger funds. A 2% fee on $5 billion produces far more recurring revenue than the same rate on $500 million, even before carried interest is considered.

Scale can benefit investors by supporting larger teams, better technology and stronger access to deals. It can also create pressure to deploy more capital into larger transactions, even when the opportunities are less attractive. A strategy that worked well with small companies may become difficult to repeat after the fund grows beyond the segment where the manager had an advantage.

This creates a tension between the economics of the management company and the interests of limited partners. The firm benefits from managing more money, while investors benefit only if that money can be invested at attractive risk-adjusted returns. A responsible manager may need to limit fund size, return unused commitments or accept that a successful strategy cannot absorb unlimited capital.

The incentive explains why assets under management receive so much attention within the industry. Carried interest may create the largest personal fortunes, but management fees build the stable business that allows the firm to survive between exits.

The Private Equity Firm Can Win Before the Company Does

A portfolio company may need years to demonstrate whether the acquisition created lasting value. The private equity firm can earn revenue throughout that period through management fees and, depending on the arrangement, other charges associated with transactions or oversight.

This timing does not mean the manager is indifferent to performance. A poor record will make the next fund difficult to raise, reduce carried interest and damage the firm’s reputation. The incentives are nevertheless uneven because the management company can remain profitable while individual portfolio companies struggle.

Some buyouts also involve dividend recapitalizations, in which the portfolio company borrows additional money and distributes a dividend to its private equity owners. The transaction can return part of the fund’s investment before the business is sold, improving the sponsor’s economics while increasing the company’s leverage. A company that later fails may have already transferred substantial cash to its owners.

These practices are legal when properly structured, but legality does not resolve the economic question. A payment that reduces the sponsor’s risk can increase the risk borne by the operating company, its creditors and employees.

Private Equity’s Record Cannot Be Reduced to Heroes or Villains

Supporters of private equity point to underperforming companies that received capital, professional management and a clearer strategy. Critics point to retailers, hospitals, nursing homes and other businesses that accumulated debt, reduced services or entered bankruptcy after buyouts.

Both outcomes occur because private equity is a financing structure rather than one uniform operating philosophy. The same tools—concentrated ownership, management incentives, acquisitions and leverage—can be used to build a stronger company or extract value from a vulnerable one.

The distinction often appears in where the return originates. A fund that improves products, expands locations and increases productivity has created something a buyer may reasonably value more highly. A fund that depends primarily on debt, asset sales, staffing reductions and a higher exit multiple may generate an impressive financial result without leaving a healthier enterprise behind.

Investors evaluating a private equity fund should therefore examine more than headline returns. They should ask how much came from earnings growth, debt repayment, leverage and valuation changes; how portfolio-company fees are handled; how often investments entered distress; and whether performance persists after all fees and expenses.

Private Equity Is Powerful Because the Risk Is Divided

Private equity combines investor capital, borrowed money, concentrated control and favorable compensation structures into one of the most powerful business models in finance. The limited partners provide most of the equity, lenders supply much of the purchase price and the acquired company produces the cash required to repay the debt. The manager directs the process, earns recurring fees and receives a significant share of successful outcomes.

When the structure works, investors can receive strong returns, managers can earn extraordinary compensation and portfolio companies can become more competitive. When it fails, the private equity fund can lose its investment, but the consequences extend further. Lenders may take losses, employees can lose jobs, vendors may go unpaid and communities can lose businesses that had existed for decades.

That distribution of risk is not an accidental flaw in private equity. It is part of what makes the model economically attractive to its managers.

Starting a private equity firm therefore requires more than learning how to raise a fund and complete a leveraged buyout. It requires deciding what kind of owner the firm intends to become. The legal documents can allocate fees, control and profits, but they cannot determine whether value will be built through better companies or extracted through increasingly aggressive financing.

The most successful private equity firms convince investors that they can do both sides of the equation well: generate attractive returns and leave behind businesses capable of surviving after the fund has taken its money and moved on.