Private equity (PE) is an alternative investment that involves buying into private companies, rather than shares of public companies traded on the stock market. Most people access PE through funds run by professional managers who identify, improve, and later sell companies, ideally for a profit. This guide walks through what private equity is, how it works, the types of PE investing, who it suits, the returns and risks involved, and how everyday investors can gain exposure.
What is private equity?
Private equity is when investors, usually through a fund, buy stakes in privately owned companies that are not listed on public stock exchanges. Fund managers then work to improve those companies and sell them for more than they paid.
Once an investment is made, PE fund managers try to steer the company toward greater profitability. They may pursue new operational strategies to run the company more efficiently and cut costs, or take a more aggressive growth approach, such as buying similar companies to build a larger, more efficient business. PE firms tend to take controlling stakes, which means management's actions are tightly aligned with the interests of shareholders, which is not always the case in public companies.
Once investors are satisfied with the improvement in profitability and the resulting higher value, they look to sell for a profit. The process is not a quick one, though: making an investment and seeing a return typically takes 5 to 10 years or more.
How do private equity firms work?
Private equity firms follow a simple cycle: buy a company, improve it, then sell it for more than they paid. They raise money from investors into a fund, use it to acquire businesses, and work to make those businesses more valuable over several years.
Buy: the firm identifies a company it believes it can improve and takes a controlling stake, often combining investor money with borrowed funds.
Improve: managers work to grow revenue and profitability, sometimes by changing operations, cutting costs, or combining the company with similar businesses.
Sell: once the company is more valuable, the firm exits by selling it or taking it public, aiming to return a profit to investors.
Because PE firms usually take controlling stakes, the people running the company and the investors who own it tend to share the same goal, which is not always the case with public companies.
Types of private equity investments
Private equity is an umbrella term for several strategies. The main ones include:
Buyouts: acquiring a controlling stake in an established company, often using borrowed money, which is known as a leveraged buyout.
Venture capital: investing in early-stage or startup companies with high growth potential.
Growth equity: investing in more mature companies that need capital to expand.
Strategy | What it involves | Typical target company |
|---|---|---|
| Buyouts | Taking a controlling stake, often with borrowed money | Established company |
| Venture capital | Backing high-growth companies at an early stage | Startup |
| Growth equity | Providing capital to help a company expand | Maturing company |
Each strategy carries a different balance of risk and potential return, but all share the same underlying idea: buying a stake in a private company with the goal of increasing its value over time.
Who is private equity for?
Private equity is for people who have an investment horizon of 4 or more years, the capacity to take on significant risk, and the ability to invest in an illiquid asset. Given the risk and required time horizon, it is mainly suited to wealth building, retirement saving, and other long-term financial goals.
Historically, access to PE has been limited to institutional investors, such as pension funds, endowments, and insurance companies. That is because alternative assets are illiquid, tend to be complex, and have high minimums. That limited access is broadening, though, as more individual investors take an interest in the returns PE has offered and as more financial institutions create products that expand its reach.
What returns can you expect from private equity?
Although past performance does not guarantee future results, private equity has historically delivered returns above public markets. From 2001 to 2023, PE returned 10.5%, compared with a global developed-markets index (MSCI World) at 5.7%*
A 2023 study published by Norges Bank Investment Management found that buyout funds have, on average, outperformed public equities by 3 to 4 percentage points a year (net of fees), while venture capital and growth equity underperformed by 1 to 2 points. The study stresses that results are highly dispersed and depend on strategy, timing, and manager selection.
Why has private equity historically outperformed public markets?
Private equity firms tend to buy smaller companies, which have historically carried higher risk, and higher potential return, than the broader market. Managers have also, on the whole, improved the profitability and growth of the companies they own.
This may be due in part to the incentives of the PE firm and the company's management team being more closely aligned than those of public equity investors and company management, which can create conditions that favour improvements in profitability. Finally, PE firms use more leverage than is typically used in public companies, which increases returns as well as risks.
What are the risks of private equity?
Private equity offers the potential for strong returns, but it comes with meaningful trade-offs that every investor should understand.
Illiquidity: your money is typically locked up for several years, so PE is not something you can sell quickly if you need cash.
Long time horizon: it often takes 5 to 10 years for an investment to play out, so returns are not immediate.
Higher risk: the use of borrowed money and the focus on smaller companies can amplify losses as well as gains.
Fees and complexity: PE funds tend to charge higher fees than public-market funds and can be harder to understand.
These features are why PE suits long-term goals and investors who can comfortably set money aside for years.
How can you invest in private equity?
For most of its history, private equity was open only to institutional investors and the very wealthy, largely because of high minimums and long lock-up periods. That is starting to change.
A growing number of funds are designed to give individual investors access to PE, sometimes with lower minimums and structures that are easier to enter and exit. If you belong to a pension plan, you may already have indirect exposure, since many pension funds invest a share of their portfolios in private equity.
Before investing, it helps to weigh the long time horizon and illiquidity against the potential returns, and to consider how PE fits alongside the rest of your portfolio.
The bottom line on private equity
Private equity is a way of investing in companies that are not listed on public stock exchanges, with the goal of improving them and selling them for a profit over several years. It has historically delivered returns above public markets, but it asks investors to accept higher risk, higher fees, and a long wait before they can access their money.
Once reserved for institutions and the wealthy, PE is gradually becoming more accessible to everyday investors. Understanding how it works, and where it fits among your long-term goals, is the first step to deciding whether it belongs in your portfolio.
*Sources: Preqin and Bloomberg. Returns are based on the Preqin Global Private Equity Index and the MSCI World Index from January 2001 to March 2023. You cannot invest in indices. The past performance of private equity or any other security or investment strategy is not an indicator of future performance, and past performance may not be repeated. All investments involve risk.
