So, What Even Is Private Equity? (And Why Should You Care?)

Full disclosure: this series exists because I have a Private Equity exam coming up, and I learn best by writing things down and pretending I am explaining them to someone mildly curious at a dinner party. If you are here for the ride, welcome. If you are also revising, solidarity.


What Is Private Equity?

The word “private” is doing a lot of heavy lifting here, and we rarely stop to appreciate it. When you buy shares in Apple or Unilever, you are buying into a publicly listed company. Prices are set by markets in real time, and you can exit whenever you like. Private equity is the opposite of almost all of that. PE involves investing in companies that are not listed on a public stock exchange. Capital is raised from institutional investors (pension funds, sovereign wealth funds, endowments, high-net-worth individuals) and pooled into a fund. That fund acquires, transforms, and eventually sells companies, with the goal of generating returns that justify the illiquidity, the fees, and the considerable patience required.

The classic PE cycle: Raise capital — Acquire a company — Create value — Exit.

The fund is managed by a General Partner (GP), the PE firm. The investors are Limited Partners (LPs), who provide capital and largely wait. Funds run for around 10 years. The GP earns a management fee (typically 2% of committed capital) and carried interest (typically 20% of profits above a hurdle rate). This is the famous “2 and 20” structure, and the incentive logic behind it matters enormously, as we will come back to.


PE vs. Other Investment Strategies
PE often gets lumped in with other alternatives, but the differences are meaningful.
PE vs. Venture Capital. Both invest in private companies; that is where the similarity ends. VC targets early-stage, high-growth businesses with high failure rates and transformative upside. PE targets mature companies with established cash flows. It is less about betting on potential and more about operational improvement and financial restructuring.

PE vs. Hedge Funds. Hedge funds operate in liquid markets and can exit positions quickly. PE capital is locked up. You commit your money and wait. The strategies are also much narrower in PE: primarily buyouts, growth equity, and distressed investing.

PE vs. Public Markets. PE firms argue they create value that public markets cannot, through active ownership and freedom from quarterly earnings pressure. The truth is deal-specific. What sets PE structurally apart is: illiquidity, active ownership, a finite fund life, and concentrated positions.

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The Agency Problem, and Why PE Is (in Theory) the Solution

To understand why PE was designed the way it was, you need to understand the problem it was built to solve.

The agency problem arises when ownership and control are separated. In a publicly listed company, shareholders own the business, but managers run it. Managers do not always act in shareholders’ interests. They might pursue empire-building acquisitions, hoard cash rather than return it, or simply avoid the risky-but-correct decisions that could cost them their jobs. Jensen and Meckling formalised this in their [landmark 1976 paper], and Jensen pushed the argument further in his famous 1989 piece, [Eclipse of the Public Corporation], where he argued PE was the superior organisational form.

PE addresses the agency problem through four structural features:

1. Concentrated ownership. The GP holds a large stake and has a direct financial incentive to maximise value. No dispersed shareholders free-riding on each other.
2. Leverage disciplines management. Debt has to be serviced. This removes the “free cash flow problem” where managers waste surplus cash on low-return projects. (More on this in the LBO article.)
3. Management equity. PE-backed management teams hold equity or options tied to the exit. When everyone’s wealth is tied to the company’s performance, operator and owner incentives converge.
4. Active boards. PE-backed companies have engaged, financially sophisticated boards asking hard questions, not passive oversight.

Elegant in theory. More complicated in practice.

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The Structures Are Changing. Are the Incentives Keeping Up?

The foundational PE model was built around specific structural features: a 10-year fund life, 2-and-20 fees, locked-up capital, and active ownership. Each feature served the incentive logic. The 10-year horizon aligned GP and LP. The carry incentivised outperformance. The illiquidity prevented short-termism.

But the industry has been evolving rapidly, and several new structural elements are worth understanding.

Subscription credit lines are short-term loans secured against LP commitments, used by GPs to bridge capital calls. They make IRR figures look better by delaying the start date of the investment clock. LPs are increasingly scrutinising this, and rightly so, because it flatters performance without creating actual value. [ILPA has published guidance on transparency expectations.]

NAV financing is a newer and more controversial tool. Here, the GP borrows at the fund level using the portfolio’s net asset value as collateral. It can be used to support existing companies, fund new investments, or accelerate distributions to LPs without selling assets. The market has grown significantly, with 17Capital estimating [$70 billion in NAV finance deployment in 2025]. The concern is that it adds leverage at the fund level, which LPs may not have signed up for, and can disguise a lack of genuine exits. When distributions come from borrowed money rather than realised gains, DPI figures flatter to deceive.

Solvency II is relevant because insurance companies are significant LP investors. The regulation imposes capital charges on insurers for holding risky assets, and under the standard formula, unlisted equity (including PE) historically carried a hefty 49% capital charge. A reformed framework, applying from January 2027, introduces a [Long-Term Equity Investment category] with a reduced 22% capital charge for qualifying PE investments. This could meaningfully expand the LP base for PE, but the qualifying criteria remain strict.

The carry tax debate is particularly live in the UK. Historically, carried interest was taxed at capital gains rates (28%), which critics argued was a subsidy for an already well-compensated industry. From April 2025, the CGT rate on carry rose to 32%. From April 2026, a new regime treats qualifying carry as deemed trading income at an effective rate of 34.075%, with non-qualifying carry taxed as high as 47%. [BDO has a clear breakdown of what changes and when.] The implications are real: if carry is taxed more like income, it weakens the incentive structure that was supposed to align GP and LP interests. The GP’s upside shrinks at the margin.

Interest rates have tested the LBO model directly. PE buyouts are typically financed with significant debt, which makes them sensitive to the cost of borrowing. When benchmark rates rose sharply from 2022 onwards, the blended interest cost on buyout debt rose with them. [Wellington Management’s analysis] illustrates the shift: a 2019 LBO might have used 6x leverage at 6% interest; a 2024 equivalent uses 4.5x leverage at 10% interest. The result is less debt in the capital structure, lower amplification of equity returns, and more pressure on operational value creation to do the work that financial engineering used to do. Global LBO volumes dropped 63.7% between 2021 and late 2023 as a direct consequence.

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The Question Worth Sitting With

The PE model was built on a specific set of incentives. The structures exist to serve those incentives. As structures change, subscription lines, NAV loans, new tax treatments, reformed capital rules, and shifting LP bases, the question the industry should keep asking is whether the incentive logic is still intact. Or whether we are preserving the form while quietly eroding what made it work.

That is the tension running through the whole course. And it starts here, in Week 1.