Private Equity Explained: Structure, Economics and the Deal Cycle

Private equity is capital invested in companies that are not traded on a public exchange, usually with the aim of owning a meaningful or controlling stake, improving the business over several years and selling it at a profit. Most private equity is raised through closed-end funds in which a general partner (GP) manages money committed by limited partners (LPs) such as pensions, endowments, insurers and family offices. The GP is paid a management fee plus a share of profits, known as carried interest.

That one-paragraph definition hides a lot of machinery. The rest of this article walks through how the pieces fit: who the participants are, how a fund moves through its life, where returns come from and how everyone gets paid.

The participants and the legal wrapper#

A typical private equity fund is a limited partnership (or a similar vehicle such as an LLC or, offshore, an exempted limited partnership). Three entities matter most:

• The fund — the partnership that owns the portfolio investments. LPs are its passive investors.
• The general partner — a special-purpose entity controlled by the sponsor's principals. It has legal authority over the fund and usually receives the carried interest.
• The management company — the operating business that employs the investment team, signs the office lease and earns the management fee under an advisory agreement.

Separating the GP from the management company keeps carry and fee income in different pockets, which matters for tax, for liability and for how the firm shares economics with junior team members. The limited partnership agreement binds everything together and sets out fees, carry, investment limits, key-person provisions and LP rights. For a deeper look at how funds are layered with feeders, parallel vehicles and blockers, see private equity fund structures.

How a fund moves through its life#

Private equity funds are closed-end: investors commit once, and the capital is not redeemable on demand. A typical lifecycle looks like this:

LPs don't wire their whole commitment on day one. The GP issues capital calls as it needs cash for deals, fees and expenses, which keeps idle capital off the fund's books and improves time-weighted returns. When an investment is sold, proceeds flow back to LPs through the distribution waterfall.

Where the returns come from#

Most buyout returns can be broken into three levers. A simple hypothetical shows how they combine.

Assume a fund buys a company with $20M of EBITDA at 10x, a $200M enterprise value, financed with $120M of debt and $80M of equity. Five years later EBITDA has grown to $30M, the exit multiple is 11x and net debt has been paid down to $70M.

The equity grows from $80M to $260M, a 3.25x gross multiple. Breaking down the $180M gain:

• Earnings growth: $10M of extra EBITDA at the entry multiple of 10x adds $100M.
• Multiple expansion: one extra turn on $30M of EBITDA adds $30M.
• Debt paydown: $50M of reduced net debt adds $50M directly to equity.

Managers who rely mainly on multiple expansion are betting on market conditions they don't control. LPs increasingly ask GPs to show this attribution for every realized deal, which is a good reason to keep entry and exit data organized from the start.

How the GP gets paid#

GP economics come in two parts.

Management fee. Usually a percentage of committed capital during the investment period, stepping down to invested capital (or a lower rate) afterward. The fee pays salaries, travel and overhead. Many agreements offset part of any transaction or monitoring fees the GP collects from portfolio companies against the management fee. See management fees for the common variants.

Carried interest. A share of fund profits, commonly 20%, paid to the GP only after LPs have received their contributed capital back plus a hurdle rate, often 8% per year, compounded. A catch-up provision then lets the GP receive a larger share until it has its full carry percentage of total profits. Whether carry is calculated on the whole fund (a European waterfall) or deal by deal (an American waterfall) changes when the GP gets paid and how much clawback risk it carries.

In the U.S., carried interest allocated to fund managers is subject to IRC §1061, which requires a holding period of more than three years for the gain to be treated as long-term capital gain.

Measuring performance#

Private equity cash flows are lumpy and the underlying assets are not marked by a market every day, so no single metric tells the whole story.

• IRR captures the timing of cash flows and rewards quick returns, but can be flattered by subscription lines and early partial exits.
• TVPI (total value to paid-in) shows the total multiple, combining realized and unrealized value.
• DPI (distributions to paid-in) shows how much cash has actually come back. Many LPs treat it as the metric that matters most once a fund is past its midpoint.
• RVPI shows the residual, still-unrealized portion.

Unrealized value depends on the GP's quarterly valuation of each holding, which is why LPs scrutinize a manager's valuation policy and look at how marks compare with eventual exit prices. Public market equivalent (PME) analysis adds a benchmark by asking what the same cash flows would have earned in an index.

The operating side most people don't see#

Behind every deal sits a substantial back office. A PE fund needs:

1. A fund-level general ledger that tracks capital, investments, income, expenses and allocations to each partner.
2. Capital call and distribution processing, including pro rata math, excused or excluded investors and default provisions.
3. Quarterly partner capital account statements and investor reports.
4. Portfolio valuations and a schedule of investments every quarter.
5. An annual audit, tax returns and Schedule K-1s for every investor.
6. Regulatory filings such as Form ADV, Form PF where applicable, and Form D for the offering.

Many firms hand part of this work to a fund administrator, but the GP remains responsible for the accuracy of what goes to investors and regulators.

Is private equity right for a given investor?#

For LPs the trade-off is simple to state and hard to manage. In exchange for illiquidity for a decade or more, high fees and limited transparency, investors hope to earn returns above public markets and get exposure to companies they cannot reach otherwise. Dispersion between top and bottom managers is wide, so manager selection, diversification across vintage years and a realistic cash flow plan (the J-curve means early years usually show negative returns) matter more than the asset class label.

How Privatis helps#

Privatis gives PE managers a double-entry fund general ledger with period close, capital call and distribution processing with waterfall calculations, management fee calculation and NAV and portfolio valuations in one system. LPs get a portal with capital account statements, documents and K-1 delivery, and every change is captured in an audit trail, so the operating side keeps pace as the firm grows from one fund to several.