Private equity is an investment partnership between a private equity firm and sophisticated investors, such as institutional and accredited investors. These investors pool their money into a fund managed by a private equity firm that invests it on their behalf, typically making equity investments into controlled companies. Private equity funds are usually illiquid investments with time horizons that can top 10 years.

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What does private equity mean?

What does private equity mean?

Private equity is an alternative investment strategy not available to the public. Most private equity funds are only open to institutional investors, including pension funds, sovereign wealth funds, and insurance companies, as well as accredited investors who typically are high-net-worth individuals or people with a high income. Most private equity investments are either in privately held companies or in public companies they take private.

The firm takes an equity investment -- an ownership interest -- in the company, usually for a controlling stake that gives the sponsor the power to make operational changes that increase the company's value.

How PE firms make money

How do private equity firms make money?

Private equity firms are investment advisors. They typically earn several revenue streams from investors in their funds, including management fees, a promote (also known as carried interest or performance revenues), and other related fees such as an acquisition or disposition fee.

Private equity fund investors pay sponsors a recurring management or advisory fee to manage their investment. The fee is usually 2% (or less) per year, based on the assets under management (AUM).

Private equity fund sponsors also earn a share of the profits generated by the investments in their fund after reaching a specific return. This promote, or carried interest, often involves splitting a share of profits. The most common is an 80/20 split, with fund investors getting 80% of the profits earned from an investment above a specific return while the sponsor receives the remaining 20% share. In addition, some private equity sponsors will charge their investors other fees, such as a bonus, when they close an acquisition.

Why PE is used

Why do investors choose private equity?

Institutions and retail investors choose alternative investments like private equity because they have historically outperformed the public stock and bond markets with less volatility, even with sponsor fees. According to data from Cambridge Associates, U.S. private equity has delivered an average annual net return of 13.8% for its investors over the 25-year period ending in mid-2022. That compares to average annual returns of 7.9% return for the Russell 2000 and 8.3% for the S&P 500 during that time frame.

Private equity investments also enable investors to build a more diversified portfolio. Because these are illiquid investments in privately held companies, their values don't change daily, like the prices of stocks and bonds, reducing volatility and a portfolio's correlation to the public stock and bond markets.

Related investing topics

Examples

Private equity firm examples

Several investment firms focus on providing investors with access to private equity investments. Blackstone (BX -2.33%) is one of the industry leaders. It started its first private equity fund in 1986. It has since grown into the leading alternative asset manager with $1 trillion in AUM as of mid-2023. Over the last 30 years, the company's corporate private equity drawdown funds have delivered 15% net returns annually for its investors.

Canada's Brookfield Asset Management (BAM -1.18%) is another leader in the alternative asset management sector. The company had about $850 million in AUM in mid-2023, including $141 million in its private equity funds. With its parent, Brookfield Corporation (BN -0.32%), Brookfield is an owner-operator that often takes large stakes in the business it acquires on behalf of investment clients. This approach enables Brookfield to participate with investors in the value it creates by operating the business.

Matthew DiLallo has positions in Blackstone, Brookfield Asset Management, and Brookfield Corporation. The Motley Fool has positions in and recommends Blackstone, Brookfield Asset Management, and Brookfield Corporation. The Motley Fool recommends Brookfield. The Motley Fool has a disclosure policy.