How Do Private Equity Firms Make Money? A Beginner’s Guide
- Rex Armani
- Aug 25
- 6 min read
Private equity can feel mysterious. This guide breaks down in plain language, how private equity (PE) firms earn fees and profits, the common exit routes they use, why PE returns often look different from public markets, and practical steps for investors who want to evaluate PE opportunities.
Table of Contents
Step 1: The two pillars of PE revenue: management fees and carried interest
Step 2: Other income streams: transaction fees, monitoring fees, and fund-tail revenue
Step 3: Exit strategies that turn work into cash (and drive profits)
Step 4: Why PE returns differ from public markets (illiquidity, leverage, and timing)
Step 5: What investors (LPs) should look for — a simple due-diligence checklist
How PE Firms Make Money
At their core, private equity firms make money two ways:
Management fees: Steady annual fees charged to investors for running the fund.
Carried interest (carry): A share of the fund’s profits once a minimum return is delivered to investors.
Beyond those, PE firms also earn from transaction-related fees, portfolio company services, and secondary or continuation-vehicle economics. The classic shorthand is “2 and 20” (about 2% management fee and 20% carry), although that exact structure is changing across the market.
Why PE Feels Mysterious
Readers often tell me: “PE sounds secretive, how do they actually turn private companies into cash?” Two things create the fog:
PE deals happen outside public markets, so there are fewer instant price tags.
Returns are realized when firms exit investments, which can take years.
This guide pulls back the curtain and explains what’s paid when, why, and what to watch for as an investor.
Step 1: The Two Pillars of PE Revenue: Management Fees and Carried Interest
Management fees — the predictable base
What it is: An annual fee (usually a percentage of committed or invested capital) that funds operations, salaries, deal sourcing, and due diligence.
Typical level: Historically around 2% (hence “2 and 20”), but industry-wide pressure has driven fee declines and negotiated discounts in many funds recently. Reports show management fees have come under downward pressure and, in aggregate, are near multi-year lows due to LP negotiating power.
Why it matters to LPs: Management fees provide a steady revenue stream for the GP regardless of performance, that’s why LPs insist on transparency and fee alignment.
Carried interest (carry) — the performance reward
What it is: A share of the profits the GP keeps after returning investors’ capital and often after a preferred return (hurdle).
Typical level: The market standard remains close to 20%, though variations and negotiated terms (hurdles, catch-ups, tiered carry) are common.
How it works (plain example):
LPs commit $100m to a fund.
The fund returns $160m at exit (a $60m profit).
If there's a hurdle of 8%, the GP only earns carry after LPs have received that preferred return. After that, the GP might take 20% of profits (so ~ $12m of the $60m), leaving LPs with the rest.
Key point: Carry aligns incentives GPs get rich only if investments beat expectations, but structuring details (hurdles, timing, clawbacks) matter to outcomes.
Step 2: Other Income Streams - Transaction Fees, Monitoring Fees, and Fund-tail Revenue
PE firms often layer additional chargeable items onto deals:
Transaction / advisory fees: Fees for arranging an acquisition or sale.
Monitoring / board fees: Fees paid by portfolio companies for board service or advisory work.
Dividend recaps & refinancing fees: When companies take on debt to pay dividends, GPs or their affiliates may earn fees.
Continuation funds & secondaries: When assets are moved into new vehicles or sold on secondary markets, GPs may collect new management fees or realize carry-like profits. These strategies have become more common as exit routes face headwinds.
Why these matter: They increase revenue even before final exits, and they explain why some firms can be cash-flow positive long before carry is realized.
Step 3: Exit Strategies That Turn Work Into Cash (and Drive Profits)
Converting private holdings into cash is essential. Common exit routes:
Trade sale (strategic sale): Sell the company to another company (very common). Recent data shows trade sales remain a dominant exit route.
IPO (initial public offering): Take the company public. IPO activity is cyclical and has weakened in some periods, reducing that exit path in tougher markets.
Secondary sale: Sell the stake to another investor or secondary buyer (a rapidly growing source of liquidity). The secondary market has grown meaningfully, representing a larger share of total exit activity in recent years.
Recapitalization / dividend recap: Restructure debt/equity to return capital to investors without a full sale.
Actionable note: If you’re evaluating a PE fund, ask the GP for their historical split of exits by type, it signals how they realize value and manage exit risk.
Step 4: Why PE Returns Differ From Public Markets
PE returns look and behave differently from public equities for several reasons:
Illiquidity premium: PE investments are illiquid — investors accept a liquidity discount in exchange for the potential of higher returns.
Leverage (debt): PE deals often use debt to boost equity returns (higher risk, higher potential upside).
Active value creation: GPs typically make operational changes, add management, cut costs, or buy bolt-ons, hands-on moves that differ from passive index investing.
Timing & measurement: PE returns are reported as IRR and multiple-of-invested-capital (MOIC), which depend on when cash flows occur and can differ from public market total return calculations.
Selection bias & survivorship: Reported industry returns can be skewed by successful funds and late-reporting under performers.
Data & context: Major industry studies and consulting reports continue to show LPs allocating to private markets even as fundraising and return patterns shift, implying LPs still see value in the private markets’ return profile relative to public markets.
Step 5: What Investors (LPs) Should Look for — A Simple Due-diligence Checklist
If you’re a potential investor or want to understand a fund’s prospects, here are concrete steps:
Fees & economics:
Ask for the management fee schedule (committed vs invested capital basis).
Check the carry percentage, hurdle rate, and catch-up provisions. (These materially change GP upside.)
Track record and realized exits:
Prefer funds with realized performance (cash returned) rather than just paper value.
Request examples of previous exits and the types (trade sale, IPO, secondary).
Alignment:
How much have the GP partners personally invested? Skin-in-the-game reduces misalignment but look at actual economics, not just headline numbers.
Strategy clarity:
Is the fund focused (e.g., buyout, growth, sector-specific) and does the strategy match market opportunities?
Risk & liquidity:
Understand the fund term, expected hold periods, and restrictions on early withdrawals. Consider whether the fund uses continuation structures or NAV loans and the implications.
Transparency & governance:
Look for detailed reporting cadence, independent valuation practices, and LP governing rights.
Practical tip: Don’t be shy. Institutional LPs routinely negotiate fee steps, preferred returns, and transparency clauses. Retail or smaller investors accessing PE through intermediaries should seek vehicles with clear fee and liquidity terms.
Real-world Examples & Recent Trends (2024–2025)
Fee pressure & negotiation: Studies and market reporting indicate management fees are being pushed lower as LPs demand better economics, management fees recently hit multi-year lows in aggregate.
Exit mix shifting: In H1 2025, trade sales outpaced IPOs as the dominant exit route; IPO volumes declined, increasing reliance on corporate buyers and secondaries.
Liquidity creativity: Continuation funds and NAV loans are increasingly used to extend hold periods or provide selective liquidity for LPs, but they raise governance and valuation questions regulators are watching.
Investor sentiment: Despite cycles, many LPs still plan to maintain or increase private market allocations, according to industry reports, suggesting PE remains a strategic allocation for many institutions.
Illustration: A recent take-private of a consumer brand (Soho House) involved private capital buyers stepping in after public-market struggles, showing how PE can be active when public listings falter.
Risks, Challenges, and How GPs/LPs are Responding
Key risks:
Valuation & mark-to-market risk: Private valuations are less frequent and rely on comps and models.
Exit risk: When IPO markets cool or strategic buyers slow, exits take longer.
Fee structures & conflicts: Transaction fees and continuation funds can raise conflict-of-interest concerns.
Responses and mitigants:
Greater LP scrutiny and tougher fund terms (fee reductions, higher disclosure).
Growth of secondaries as an exit and liquidity tool.
More nuanced GP economics (step-down fees, tiered carry, co-invest opportunities).
Clear Takeaways & Next Actions
PE firms mainly make money from management fees + carried interest, with meaningful supplementary fee lines. (Remember the “2 and 20” shorthand — but know it is evolving.)
Exits drive payoffs. Understanding how and when a GP expects to exit portfolio companies is vital.
If you’re evaluating PE: focus on economics, alignment, track record, and transparency. Use the checklist above.
FAQs: Short Answers to Common Beginner Questions
Q: Is “2 and 20” still the market norm?
A: It’s still a common baseline, but the market is changing. Many funds now negotiate lower management fees, tiered carry, or different fee bases. Always check the limited partnership agreement (LPA).
Q: When do GPs actually get paid?
A: Management fees are ongoing; carry is paid when profits are realized (post-hurdle) and after certain waterfall mechanics. That could be years after the initial investment.
Q: Can retail investors invest in PE?
A: Yes, indirectly. Options include listed private equity firms, interval funds, business development companies (BDCs), and secondary or listed vehicles. Each has different risk/liquidity profiles.
Closing
Private equity isn't magic, it’s a business model built on patient capital, operational intervention, leverage, and carefully timed exits. Understanding the fee mechanics (management fees, carried interest), the practical ways firms earn extra cash, and the real exit pathways brings that mystery into view.
