The Machine Behind the Curtain: How Private Equity Actually Works

There's a reasonable chance that somewhere in the fine print of your pension plan, your university's investment portfolio, or the insurance policy in a drawer at home, a portion of your financial future is already committed to a private equity fund. You never attended a meeting. You never signed a subscription document. You never shook hands with a fund manager. But you're in.

Private equity is not a game played exclusively by the ultra-wealthy in closed rooms. The dominant capital behind the industry's most aggressive buyouts comes from pension funds for teachers and firefighters, university endowments, sovereign wealth funds, and insurance companies. The Yale Endowment, under the late David Swensen, pioneered this model in the 1980s and 1990s, allocating heavily to private markets in search of returns that public stocks and bonds couldn't reliably deliver, and every major institutional investor copied the playbook. The result is a system where ordinary workers are the silent capital behind deals that reshape industries, eliminate jobs, and occasionally generate extraordinary wealth, often without the workers knowing any of it is happening. Understanding how private equity works is not a luxury for finance professionals. It's a form of literacy most people are never given.

First, Let's Clear Up the Confusion

People frequently use "hedge fund" and "private equity fund" interchangeably. They are different animals. A hedge fund typically trades securities, such as stocks, bonds, derivatives, and currencies, and can move in and out of positions quickly. A private equity fund buys whole companies or controlling stakes in them, holds those companies for years, tries to improve them, and then sells. One is a trading operation. The other is a long-term ownership business. This article focuses on buyout funds, the most common and consequential type. Private equity also includes growth equity (minority stakes in growing companies) and venture capital (early-stage bets on startups), but buyouts are the engine of the industry, and they're where the most interesting mechanics live.

The Structure: Who's In the Room

A private equity fund is organized as a limited partnership, a legal structure that divides participants into two roles with very different levels of power and liability. The limited partners, or LPs, are the outside investors: pension funds, endowments, sovereign wealth funds, insurance companies, and wealthy family offices that provide most of the capital, usually 98 to 99 percent of it. LPs commit capital but have no say in how it's invested, and in exchange for giving up control they get limited liability, meaning they can't lose more than they put in. The general partner, or GP, is the private equity firm itself, the KKRs and Blackstones and Apollos of the world. The GP makes every investment decision, manages the portfolio companies, and eventually sells them, typically contributing 1 to 2 percent of the fund's capital as a show of skin in the game.

LPs don't hand over all their money on day one. They commit capital, and the GP calls that capital over time as deals are identified. A $10 billion fund might only have $3 billion actually deployed in its second year. The fund typically runs for 10 to 12 years, long enough to find companies, improve them, and exit at a profit.

How the Firm Gets Paid (Before Any Deals Close)

Private equity firms charge two types of fees. The first is a management fee, typically around 2 percent of committed capital per year during the fund's investment period. On a $10 billion fund, that's roughly $200 million a year. Every year. Before a single portfolio company is sold, before a single dollar of profit is realized. That number deserves a moment of attention. The private equity firm is already running a highly profitable business from the day the fund closes. When Blackstone, KKR, and Apollo went public, in 2007, 2010, and 2011 respectively, their stock prices reflected this reality: these are fee-generating businesses that also make investments, not investment businesses that happen to charge fees.

The second form of compensation is carried interest, or carry. This is the GP's share of the fund's investment profits, typically 20 percent. If a fund generates $5 billion in profit above what investors put in, the GP takes $1 billion and the remaining $4 billion goes to the LPs. That $1 billion is the prize the firm is ultimately chasing, and it's why the partners at successful firms become extraordinarily wealthy. Carry is not guaranteed. It only kicks in after a threshold is cleared.

The Hurdle: Investors Get Paid First

Before the GP collects a dollar of carry, the LPs must receive their capital back plus a minimum return. This minimum is called the hurdle rate, typically set at 8 percent annually. Think of it like a performance-bonus structure: the manager only gets the bonus if results clear a certain bar. Below the bar, investors keep everything. Above it, profits start to split.

Once the hurdle is cleared, there's usually a catch-up provision: the GP temporarily receives a larger share of distributions, sometimes 100 percent, until the total profit split reaches the agreed ratio, usually 80/20. After that, all remaining profits split at that ratio going forward. The hurdle protects investors from paying performance fees on mediocre results. The catch-up restores the agreed profit-sharing ratio once investors have been made whole. It's a structure designed to align incentives, though, like any financial structure, it can be gamed by managers who are creative with their accounting.

The LBO: Why Private Equity Loves Debt

The leveraged buyout, or LBO, is the signature move of private equity and also the most misunderstood. A leveraged buyout means acquiring a company using a combination of equity (the fund's own capital) and debt (borrowed money). The typical split is roughly 30 to 40 percent equity, 60 to 70 percent debt. Critically, the debt goes on the acquired company's balance sheet, not the fund's, and the company services the loan from its own cash flows.

Here is why this matters mathematically. Suppose a fund buys a company for $1 billion: $300 million in equity, $700 million borrowed. Five years later, the company sells for $2 billion. After repaying the $700 million in debt, the equity holder receives $1.3 billion. The fund didn't double its money; it more than quadrupled it, turning $300 million into $1.3 billion. Enterprise value doubled, but return on equity was roughly four times. That is the amplification logic of leverage, and the risk runs in both directions. If the same company declines to $800 million, the equity holder receives only $100 million after repaying the debt, losing two-thirds of their investment even though enterprise value only fell 20 percent.

The Toys "R" Us bankruptcy in 2017 illustrated what happens when a heavily leveraged company faces a structural industry shift and can't invest in its own operations because every dollar is servicing loans. The Hilton Hotels deal tells the other story. Blackstone bought Hilton in 2007 for $26 billion, including $20 billion in debt, at almost the worst possible moment, just before the financial crisis. The investment nearly failed. Blackstone held on, restructured, and eventually made approximately $14 billion in profit. The same lever that nearly destroyed the investment ultimately amplified the recovery into one of the most profitable buyouts in history.

Co-Investments: When LPs Go Direct

Sometimes a deal is larger than a single fund can absorb. Sometimes a GP wants to deepen a relationship with a key LP. In these situations the GP may offer co-investment rights: the LP invests directly alongside the fund in a specific deal, usually at reduced fees or no carry at all. For LPs this is highly attractive, offering direct exposure to a specific asset they've evaluated and chosen, at lower cost than going through the fund. For GPs it's a relationship tool and a way to close larger deals without overconcentrating the fund in a single position. Co-investments have become increasingly common as large LPs have built internal teams capable of evaluating individual deals.

Club Deals: Sharing the Risk

When a target company is very large or carries unusual risk, multiple private equity firms may acquire it together. This is called a club deal, and the logic is practical. Deal size may exceed what any single fund can absorb within its concentration limits, and complex industries such as energy infrastructure, regulated utilities, and global hotel chains may benefit from the different expertise of multiple GP teams. The 2007 buyout of TXU Energy by KKR, TPG Capital, and Goldman Sachs for $45 billion was the largest leveraged buyout in history at the time. It later became one of the largest bankruptcies in U.S. history, a cautionary note about the limits of even the most sophisticated club arrangements when commodity prices move against you.

The Pitch: The Machine Never Stops Selling

Because a fund has a finite life, a private equity firm must raise a new fund roughly every three to five years to maintain its fee base and keep its teams employed. The firm is always simultaneously deploying capital, managing existing portfolio companies, harvesting exits from older investments, and raising the next fund. The pitch never stops. When a firm sits across from a pension fund or university endowment, the conversation follows a familiar architecture. Track record: here is what our previous funds returned, net of fees, compared to the public-market benchmark. Deal sourcing: here is why we see opportunities others don't. Operational expertise: we don't just buy companies, we improve them. Disciplined leverage: we use debt carefully, calibrated to the company's cash flows. And the implied promise underneath all of it: your capital is better here than anywhere else.

Whether that promise is consistently delivered is a matter of genuine academic debate. Research by Harvard Business School's Josh Lerner and others has shown that top-quartile PE managers tend to stay top-quartile, with performance persisting in ways it doesn't in most asset classes. Other researchers have argued that when returns are properly risk-adjusted, the outperformance over public markets is less impressive than the industry's marketing suggests. The honest answer is that it depends on the manager, the vintage year, and whether the LP is sophisticated enough to access the top funds, which are typically oversubscribed and don't need new investors.

What This Machine Actually Is

Private equity is often described as a financial innovation. It is more accurate to describe it as a business model, one that combines investor capital, borrowed money, operational pressure, and time into a machine that generates fees regardless of outcomes and carry when things go right. The structure is genuinely designed to align incentives: the hurdle protects LPs, the carry motivates GPs, the co-investment option rewards sophisticated partners, and the long fund life forces a long-term orientation that quarterly earnings pressure doesn't allow. At its best, private equity takes underperforming businesses, applies capital and expertise, and creates real value for investors and employees alike. At its worst, it loads companies with debt they can't carry, extracts fees while the business deteriorates, and leaves workers and creditors holding the pieces.

Both stories are true often enough to be taken seriously. What matters is understanding that this machine is already running, that your money is probably already inside it, and that the decisions being made in conference rooms and pitch meetings have real consequences for real companies and real people. The first step to having an opinion about that is understanding how it works. Now you do.