Private Equity: A Primer

Introduction

Private equity (PE) is simply the investment in companies that are not publicly traded and are not SEC registered. Allocations to PE have been increasing in portfolios, with US state pension funds holding 15% of their assets in PE, a significant increase over the 9% allocation reported five years ago (Arnott 2025). In 2020, the US Department of Labor published guidance on the use of PE in 401(K) plans as part of a diversified investment option (Arnott and CFA 2025). 

As of H1 2024, the total reported value of PE firms was approximately USD 9T, which is far less than the USD 124T of global public equities (Neufeld and Kostandi, n.d.). The USD 9T constitutes a record level in the PE space, but it does mask the fact that the total value of annual PE deals has continued to fall since its peak of USD 3T in 2021 (Brown and Munichiello, n.d.). 

A primary reason for the growth in the PE market, according to economists, is that companies are remaining private longer. Focusing on the United States, in 1997 there were over 6,500 publicly listed companies and as of September 2024, there were only 4,700, which does represent an improvement over the 2012 low of 3,800. A similar situation has occurred in the UK, where in the 1960s there were more than 4,400 public companies, but today there are only 1,200 (Meketa, 2024). Various reasons have been given for the consolidation of the public markets, including: 

1. Regulatory burdens: greater regulatory requirements increase the cost of compliance and dissuade companies from listing
2. Greater private capital and decreased regulatory oversight: the SEC appears committed to increasing access to private markets. In 2020, non-accredited investors with certain certifications were granted private market access (Knutson, n.d.). Moreover, in 2024, the US Court of Appeals vacated the SEC’s private fund adviser rules, and in February 2024 the acting SEC chairman, Mark T. Uyeda, promoted SEC priorities focused on fostering “innovation, job creation, and economic growth” in PE (LLP 2025).
3. Mergers and acquisitions (M&A): greater consolidation has resulted in companies being delisted
4. Market concentration: the public markets are far more concentrated than historical levels
5. Innovative means of increasing investor deal access

Essentially, through a disparate but concurrent effort by the government, challenges associated with being public, and a vigorous attempt by fund managers to facilitate access, private markets are enjoying extraordinary growth while public markets wither. As of April 1, 2025, there were over 1,400 unicorn companies, which is the term used in PE to describe companies valued at over USD 1B. 

PE Investment Strategies

The PE market manages strategies with varying degrees of risk and reward that fit idiosyncratic investor appetites (Blazej, n.d.). 

Why Invest And Understanding Performance

Performance is why investors allocate to PE. According to Morningstar, the PitchBook PE AII US Index has returned 13.4% per year since 1999, outperforming publicly traded US stocks as proxied by the Morningstar US Market Index by approximately 5% per year. That is a considerable margin, and when coupled with PE’s reported lower volatility, it makes a compelling case for foregoing liquidity. However, the PE sector is not subject to the same disclosure requirements as public companies, and thus, it does not report performance as transparently as public companies. In fact, PE is known to apply considerable subjectivity in its performance calculations. 

PE performance is typically tabulated via the internal rate of return (IRR). In IRR, the timing and size of cash flows significantly affect the performance. Cash flows are also assumed to be invested at the IRR for the life of the fund, meaning that if the investor receives an early distribution, the fund assumes that distributions are reallocated at the fund’s IRR. Moreover, unlike total return analysis, which is standardized and subject to global investment performance standards, IRR does not have a standardized methodology and is vulnerable to manipulation, both in terms of cash flow timing and exit. The lack of standardization makes comparing different PE funds far more complex than comparing public market products. 

To add additional convolution to the equation, PE funds value themselves at lagged intervals, that again are not standardized. This creates performance smoothing, which influences both return and volatility. Risk is highly sensitive to smoothing, resulting in the statistically spurious autocorrelations that understate an investment’s risk exposures (Couts et. al, 2019). The phenomenon of performance smoothing is well documented and empirically researched. There are several methods of de-smoothing returns, premised largely in econometric methodologies. 

Yet, even if performance can be de-smoothed so that it may be better analyzed alongside public investments, the data itself may be spurious. This is because PE is a caveat emptor investment. In other words, the investor must beware, the manger is commonly the ultimate arbiter of what is reported and how. 

Perhaps the lack of transparency is the reason why the SEC requires individual PE investors to meet either specific financial or professional criteria (SEC, n.d.).

• Financial Criteria
  • Net worth over $1 million, excluding primary residence (individually or with spouse or partner)
  • Income over $200,000 (individually) or $300,000 (with spouse or partner) in each of the prior two years, and reasonably expects the same for the current year
• Professional Criteria (added 2020)
  • Investment professionals in good standing holding the general securities representative license (Series 7), the investment adviser representative license (Series 65), or the private securities offerings representative license (Series 82)
  • Directors, executive officers, or general partners (GP) of the company selling the securities (or of a GP of that company)
  • Any “family client” of a “family office” that qualifies as an accredited investor
  • For investments in a private fund, “knowledgeable employees” of the fund

Due to the issues endemic to measuring returns of PE via IRR, the industry now frequently reports performance in the form of modified IRR, multiple on invested capital (MOIC), total value to paid in (TVPI), distributed capital to paid in capital ratio (DPI), and public market equivalent (PME) (Carta, n.d.). 

• Modified IRR: overcomes the reinvestment assumption of standard IRR by assuming LP cash flows are reinvested at a more realistic rate of return (ROR). Additionally, modified IRR considers the effect of uncalled capital (Hayes, Khartit, and Ma, n.d.):

• Where,
• MOIC: a cash-on-cash return and is calculated as: 

• TVPI: the sum of both the realized and residual value of the fund’s unrealized investments (i.e., valuation of held investments):

• DPI: the ratio of cumulative distributions to the total capital investors have paid:

• PME: a method of comparing public market to private market performance by evaluating how a capital called in a private fund would have performed had it been invested in public markets. There are several means of calculation, each with slightly differing results (FactSet, n.d.):
  1. Long Nickles
  2. Kaplan Scholar
  3. Direct Alpha
  4. PME+ and mPME
  5. GEM IPP

Essentially, there are several ways to evaluate the performance of PE funds. Each methodology has its unique pros and cons. Thus, when studying a fund’s performance, it is advised that an investor diversely approaches analysis. 

Fees and Basic Due Diligence

Investors should understand a fund’s fees before investing, since they materially affect any future return on investment (ROI). There are several layers of fees, and various ways to calculate them, including but not limited to: 

1. Load fee: a term that may either refer to the sales fee on a PE fund, and is generally a percentage of the committed, or it may refer to a fee charged by the GP to affiliated entities for additional leverage
2. Management fee: a fee generally charged on committed capital ranging from 1% to 3%
3. Incentive fee/carried interest: an additional fee charged on top of the above-mentioned fees, and it is related to fund performance. Oftentimes, there is a preferred return that is distributed to investors before the performance fee is charged, but not always. The fee is typically between 8% to 20%
4.  Exit/redemption fee: a fee charged to investors when they redeem their ownership interest in the fund

An example of the impact of fees on investor performance is illustrated using the Renaissance Technology Medallion Fund (RenTech). RenTech is generally considered one of the most successful hedge funds. In 2008, the fund returned 98.2% while the S&P lost 38.5%. Between 1988 and 2021, the fund has averaged 37% annualized returns (Maggiulli 2023). The fees for the Medallion fund are comparatively straightforward at a 5% management and 44% performance. That means that in a year the fund returns 35%, and the incentive fee is charged on the starting NAV, the net return to the investor is (Pearson 2025):

While 16.8% is a remarkable return, the example illustrates the significant impact fees can have on performance. Moreover, RenTech is an exceptional fund. Most funds will never do this well. 

Another consideration is the asymmetry of fees. Fund managers are compensated regardless of the fund's performance. When there is a large incentive fee, the fund essentially has little downside exposure, with outsized upside potential. Hence, the fee structure is itself a tool to motivate risk taking. Basically, an incentive fee is a call option on the fund’s net profit. As with any call option, greater volatility increases the option's value. The incentive fee in a classic 2% and 20% can be thought of as: 

Where A is the assets under management (AUM) at the beginning of the year and R is the return on the assets during the year. The equation represents the payoff from a call option with a strike price equal to 2% of AUM. In this scenario, the fund is fully exposed to the upside but hedged against the downside (Pearson 2025). 

Of course, motivating a fund manager to take risk, either in the form of increased leverage or higher risk investments, is not inherently a poor structure. By motivating the manger to assume more risk, the client is, theoretically, enhancing their upside potential. 

The point is, fees can be complicated and opaque and deserve consideration. Any fee will affect performance. Therefore, it is important, as in the case of RenTech, the performance justifies the fees. The fees should not justify the performance. 

Beyond strictly costs, investors should consider the fund’s legal documents, including but not limited to sections on the distribution waterfall, clawback provisions, the term of the fund, potential extensions, the exit strategy, the share class to which the investor is entitled, the fund’s identified strategy (where specificity is paramount to breadth), indemnifications, and tax implications. Additionally, and of considerable importance is the fund’s GP and the management team. Understanding the history of the GP’s previous funds is invaluable information that should be reviewed before committing. Further, all past performance should be examined alongside the macroeconomic environment in which the fund was operating (i.e., a manager who excels in a low inflation and low cost of capital environment may not fare as well in a moderate inflation and high cost of capital market). 

How to Invest

Access to PE funds is complicated, even for accredited investors. Direct investments, typically in the form of a GP-LP structure (General Partner and Limited Partner vehicle) frequently exceed USD 1M. Therefore, if an investor wishes to create a minimally diversified portfolio of direct investments in PE, it will require north of USD 20M (Arnott 2025). The advantage of going direct is the cost savings. Management fees are lower, the profit-sharing systems are simpler, and transparency is often improved. 

For investors that do not have the capacity to allocate USD 1M to a direct deal, there are various fund options. Some structures may even enhance liquidity versus traditional PE funds, offering an early redemption option to investors. Typically, the right to early withdrawal comes with an exit fee, but it does address one of the most significant challenges of PE, the lack of liquidity. 

Within the PE fund space, again, there is variety, with open-end funds, funds, and evergreen funds (redeemable funds). There are funds that directly invest into a single manager's strategy, though the minimum investment amount tends to be high, making it hard to build a diversified portfolio. Therefore, the fund of funds (FOF) evolved into a solution for less well-heeled investors looking to diversify across disparate sectors and vintages. In the FOF vehicle, clients pool their capital under a master fund, which then itself allocates across several fund managers. The advantage of the FOF is its intrinsic diversification and lower entry point. The disadvantage is the high fees, which are typically layered, and lower absolute returns. 

The simplest vehicle for clients wishing to gain exposure to the PE space is to purchase publicly traded equities in PE companies, either directly, as in the case of KKR, or via an ETF, such as Invesco Global Listed Private Equity ETF. The advantage of going through the public markets is high liquidity, lower costs, and a degree of diversification. The disadvantage is potentially lower returns. 

Exit Strategies

A fund’s exit strategy is key to monetizing an investor's ownership interest. The typical PE fund will have a lock-up period of 10 years with two 1-year extensions, commonly referred to as the 10+2. The extensions are generally granted at the sole discretion of the GP, but in some cases, they are also contingent upon the limited partners action committee (LPAC). The total exit and the partial exit are the two primary liquidation events, which can be further subdivided into sub-strategies (CFI Team, n.d.): 

1. Total exit
   1. Trade Sale
   2. Leveraged buyout (LBO)
   3. Shares repurchase
2. Partial Exit
   1. Private placement
   2. Corporate venturing
   3. Corporate restructuring 

The listed strategies are the broadest forms of common exists. There are variations on how each may be executed, including the fast-growing market of secondary shares, which are essentially the seasoned ownership stakes in a fund that are being offered by a shareholder of the issuer and not the issuer themselves. The secondary market began in the 1980s as a way for investors to liquidate their holdings in privately held funds. Originally, secondaries could be bought at steep discounts to fund NAV and were considered last-resort markets for desperate sellers. Today, the secondaries market is a reputable and well-established means of accessing liquidity for both GPs and LPs, and it frequently trades at NAV or even a premium to NAV. 

Conclusion

Private equity can be a solid addition to a diversified portfolio. In the contemporaneous market, if companies do go public, they are doing it at far later maturities. As such, there are many dynamic, high-growth companies to be found in private markets. The sector’s lack of standardization makes analyzing opportunities much more complicated than researching an equivalent public market investment. Moreover, PE, by its nature, embraces opacity. Companies electing to remain private value their lack of transparency and regulation. If private companies have access to less restrictive and, oftentimes, less expensive capital, why would they go public? 

For well diversified investors willing to put in the work, private equity offers the potential for higher returns. Over the last 24 years, private equity has outperformed US public equities in terms of absolute returns, lower volatility, and shorter drawdowns. However, the data is subject to self-reporting and sensitive to manipulation. Morningstar suggests allocations to PE be made for at least 10 years due to the historical frequency of losses over various rolling time periods (Arnott 2025). Regarding a recommended portfolio allocation, if it is based on global market percentages, in 2024, US PE was valued at about USD 10.8T versus the global equity markets at USD 124T. Therefore, when benchmarking against PE’s global market allotment, Morningstar advises an allocation of 9% or less (Arnott 2025). 

In summary, investors in PE should expect higher returns because they are accepting more risk. Furthermore, the analysis of a PE fund does mandate detailed scrutiny. Fees, structure, legal documents (if available), manager history, investment strategy, tax implications, and exit plans are required minimum reading. Finally, an investor in traditional GP/LP structures and in closed-end funds should be comfortable foregoing ready liquidity. With patience and a willingness to accept greater risk, the investor may realize outsized future returns. 

Sources:

Arnott, Amy C. 2025. “How to Use Private Equity in Your Portfolio.” Morningstar, Inc. April 1, 2025. https://www.morningstar.com/alternative-investments/how-use-private-equity-your-portfolio.

Brown, Jefreda R., and Katrina Munichiello. n.d. “Understanding Private Equity (PE).” Investopedia. Accessed June 9, 2025. https://www.investopedia.com/articles/financial-careers/09/private-equity.asp.

Carta. n.d. “Carta APAC | The End-to-End Suite Connecting Private Capital.” Carta. Accessed June 10, 2025. https://carta.com/sg/en/.

CFI Team. n.d. “Private Equity Funds.” Corporate Finance Institute (blog). Accessed June 9, 2025. https://corporatefinanceinstitute.com/resources/wealth-management/private-equity-funds/.

Couts, Spencer, Andrei S Goncalves, and Andrea Rossi. n.d. “Unsmoothing Returns of Illiquid Assets.”

FactSet. n.d. “Measuring Performance in Private Equity: The PME Cheat Sheet.” Accessed June 10, 2025. https://www.factset.com/resource/white-paper/measuring-performance-in-private-equity-the-pme-cheat-sheet.

Hayes, Adam, Khadija Khartit, and Jiwon Ma. n.d. “Modified Internal Rate of Return – MIRR Definition.” Investopedia. Accessed June 10, 2025. https://www.investopedia.com/terms/m/mirr.asp.

Knutson, Ted. n.d. “SEC Gives More Retail Investors Access To Private Funds, Companies.” Forbes. Accessed June 9, 2025. https://www.forbes.com/sites/tedknutson/2020/08/26/sec-gives-more-retail-investors-access-to-private-funds-companies/.

LLP, Latham & Watkins. 2025. “SEC Explores Regulatory Changes to Make It Easier to Raise Capital, Invest in Private Funds, and Be a Public Company.” Beyond the First 100 Days (blog). February 27, 2025. https://www.lathamreg.com/2025/02/sec-explores-regulatory-changes-to-make-it-easier-to-raise-capital-invest-in-private-funds-and-be-a-public-company/.

Maggiulli, Nick. 2023. “Why the Medallion Fund Is the Greatest Money-Making Machine of All Time.” February 16, 2023. https://ofdollarsanddata.com/medallion-fund/.

Neufeld, Dorothy, and Christina Kostandi. n.d. “The $124 Trillion Global Stock Market, Sorted by Region.” Accessed June 9, 2025. https://www.visualcapitalist.com/124-trillion-global-stock-market-by-region/.

Blazej, Kupec. n.d. “Not All Private Market Strategies Are Created Equal. Here’s How They Compare.” Accessed June 11, 2025. https://www.moonfare.com/blog/private-market-strategies-comparison.

Pearson. 2025. FRM Part 1: Financial Markets & Products. 2025th ed. 221 River Street, Hoboken NJ 07030: Pearson.

SEC. n.d. “SEC.Gov | Accredited Investors.” Accessed June 10, 2025. https://www.sec.gov/resources-small-businesses/capital-raising-building-blocks/accredited-investors.

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