What Is Private Equity?

Private equity is having a moment.

Over the past two decades, global private equity assets under management have increased some 1,200%—from $744 billion in 2004 to $9.7 trillion¹ as of December 2024—driven primarily by investors' desire for higher returns than those generally provided by public equity markets.

"That's the main argument for private equity funds—their outperformance of public markets," says Ken Pennington, CFA^®, director of alternative investments research at the Schwab Center for Financial Research.

Unlike stocks traded on public exchanges, the shares of private companies are not widely available. Instead, investors normally access them through a private equity fund, which is run by a general partner (GP) who identifies, acquires, and manages a portfolio of privately held companies with the goal of generating returns that beat the stock market.

There are three main strategy types within the private equity universe:

• Venture capital, which invests in both early-stage ventures—where companies are still very young and innovative with limited historical financials—and late-stage ventures seeking expansion.
• Growth equity, which typically invests in firms that are profitable or have a clear path to profitability in an industry or subsector, with proven business models bolstered by established products and growing customer bases.
• Buyout, which generally focuses on purchasing majority ownership and control of mature companies with a track record of stable revenues and cash flows, often using a combination of equity and debt.

Historically, private equity funds have used a closed-end, drawdown structure, where investors, called limited partners (LPs), commit to a large, up-front capital investment—often $5 million or more—during the fundraising phase. Drawdown funds ordinarily don't take investors' principal all at once; instead, fund managers make capital calls, or formal demands for a portion of the investor's total committed capital, to fund new investment opportunities. Investors are usually required to respond to such capital calls within seven to 14 days, which means they can keep their capital invested—ideally in highly liquid investments—while they wait for a call.

"Drawdown funds do not give private equity investors the ability to redeem their investment on demand," Ken says. "Rather, they typically require investors to lock up their money for up to 10 years or more, returning capital to investors only when the fund sells assets and distributes the proceeds."

That illiquidity might seem like a drawback, but it's what gives private equity funds their edge. Locking up capital for a longer period allows managers more time to make operational improvements, turn a troubled company around, or bring a growth strategy to fruition—insulated from the pressures that may come from swings in a company's stock price.

"This potential for excess returns is referred to as an illiquidity premium," Ken says, "and it's one of the key reasons private equity assets may offer higher returns than public equities."

Indeed, over the 25-year period ending in 2023, the Cambridge Associates Global Private Equity Index (a broad-based benchmark for the global private equity market) outperformed the MSCI World Index (a broad-based benchmark for the global public equity market) by more than 6 percentage points annually on a net basis.²

There can be enormous disparities in the performance of traditional private equity funds. While the top quartile of global actively managed mutual funds commonly outperforms the average annual return of those in the bottom quartile by 1.9 percentage points,³ the top quartile of global private equity funds can outperform the bottom quartile by as much as 20.9 percentage points.⁴

Because of drawdown funds' high investment minimums, investing in private equity historically has been limited to endowments, large institutions, and the ultrawealthy.

However, over the last decade, the asset management industry has introduced fund structures that are accessible to more investors, thanks to features such as:

• Investment minimums as low as $10,000–$25,000.
• The ability to periodically redeem at least a portion of their investment.
• Streamlined tax reporting by issuing 1099s instead of K-1s.

Additionally, the rise in so-called evergreen funds has provided a more flexible way for investors to access private markets.

Evergreen funds tend to invest capital immediately into an existing portfolio of private companies or other assets and have no end date, allowing the fund to continuously invest according to its mandate. They do still have some redemption restrictions, which can include minimum holding periods, early redemption penalties, or other redemption limits to help manage liquidity.

"While these new structures are more liquid than drawdown funds, their underlying assets are still illiquid, so you'll never have the kind of access to your capital that you do with publicly traded funds," Ken says.

Private equity funds generally have fee structures that include an annual management fee of around 1%–2% of assets, plus a performance fee (also called "carried interest") of 15%–20% of profits if returns exceed a certain hurdle rate—often around 8%. Both drawdown and evergreen funds may follow this fee structure, but that's where their cost similarities end:

• Drawdown funds normally base their initial management fees on committed capital, meaning on the money that an investor has agreed to contribute even if it hasn't yet been paid in. As the fund matures, the fee structure may shift to net asset value (NAV)—the fund's assets minus its liabilities—which can lower costs as assets are sold. The manager's share of the profits ordinarily is taken after the fund has returned investors' original investment and cleared the profit hurdle.

• Evergreen funds, by contrast, usually tie management fees to their NAV from the outset, meaning investors pay fees only on capital the fund has actually deployed.

  Because the funds operate continuously, performance is assessed at regular intervals—often annually—to determine whether the manager has exceeded the profit threshold. This means the manager's share of profits can be based on both realized and unrealized gains, whereas a drawdown fund manager's share of profits is typically based strictly on realized gains.

So, how can an individual investor get the most out of this complex, expensive asset class? As with most alternative assets, the key lies in careful due diligence and a disciplined evaluation process. Consider:

• Illiquidity: The chief concern with private equity for retail investors has always been the long-term lockup requirements. While evergreen funds have improved that picture, they remain highly illiquid compared with publicly traded funds. As a result, you should carefully evaluate the term length, redemption options, and distribution policies to ensure they align with your expectations and needs.
• Manager selection: The GP can be critical to a fund's performance. To help avoid getting locked into a fund whose manager is underperforming—with no easy way out—assess the GP's track record, ideally across multiple market cycles and strategies.
• Valuation: Funds rely on manager estimates to value illiquid companies, which can be imprecise or influenced by optimistic assumptions. If valuations are overstated, investors may believe the fund is performing better than it truly is, masking underlying problems until assets are sold.
• Fees and expenses: Compared with traditional investments such as mutual funds or ETFs, private equity funds typically have much higher fees. Are you willing to potentially give up a significant percentage of your profits on top of an annual management fee? If so, at least ensure the fund's management fees and carried interest are in line with industry norms.

The potential for excess returns is appealing, to be sure, but investing in private equity carries considerable risks. It may be most suitable for investors who have:

• A long time horizon: You must be able and willing to tie up some of your capital for a decade or more. Even evergreen funds that buy back shares at regular intervals can take years to return capital and distribute profits.
• Ample liquidity: It's important to have adequate funds outside of your private equity investments to serve your liquidity needs.
• Comfort with complexity: Fund and tax structures, liquidity payouts, and underlying valuations can be complicated.

"For sophisticated investors with long time horizons and a lot of capital, we believe private equity could make sense as part of a diversified portfolio—so long as they're getting broad exposure to different strategies and their combined private and public holdings don't exceed their target equity allocations," Ken says.