A private equity fund works by pooling money from a small group of wealthy and institutional investors into a limited partnership that buys private companies, improves them over several years, and sells them for a profit. You commit a set amount of capital up front, but the fund manager only calls that money as deals come up. In exchange for running the fund, the manager collects an annual fee of around 2% and keeps roughly 20% of the profits once investors have been paid back and cleared a minimum return. Your money is largely locked up for about ten years, and you receive cash back only as portfolio companies are sold.
That is the shape of it. The details below cover who is allowed in, how the fund is put together, when money moves in each direction, and how returns are measured and taxed.
Who Is Allowed to Invest
Private equity funds do not register with the SEC the way mutual funds do. To keep that exemption, they limit who can put money in. Almost every fund requires you to be an accredited investor, and larger funds require you to clear a higher bar called qualified purchaser.
Under SEC Rule 501 of Regulation D, you qualify as an accredited investor if your individual income was above $200,000 in each of the last two years (or $300,000 jointly with a spouse) with the same expected this year, or if your net worth exceeds $1,000,000 excluding your primary residence.1eCFR. 17 CFR 230.501 – Definitions and Terms Used in Regulation D Certain professionals holding Series 7, Series 65, or Series 82 licenses qualify as well.
To be a qualified purchaser, an individual must own at least $5,000,000 in investments.2Legal Information Institute. 15 U.S. Code 80a-2(a)(51) – Qualified Purchaser Definition Funds that stick to accredited investors are usually capped at 100 beneficial owners under the Investment Company Act, while funds that admit only qualified purchasers can accept an unlimited number.3Office of the Law Revision Counsel. 15 U.S. Code 80a-3 – Definition of Investment Company That is why the largest funds set the higher threshold.
How the Fund Is Structured
A private equity fund is a limited partnership. That legal form separates the people running the money from the people supplying it, and it defines who is exposed to what.
The General Partner
The general partner, or GP, makes every investment decision: which companies to buy, how to manage them, and when to sell. The GP signs contracts on behalf of the fund and carries unlimited personal liability for its debts. To insulate the humans doing the work, the GP is almost always itself a limited liability entity rather than a natural person.
The Limited Partners
Limited partners, or LPs, supply the capital. Pension funds, endowments, insurance companies, sovereign wealth funds, and wealthy individuals are the usual mix. An LP’s financial exposure is capped at the amount committed. In return for that protection, LPs cannot participate in running the fund. Under Delaware partnership law, which governs most U.S. private equity funds, an LP who involves themselves in day-to-day control can lose the liability shield and become personally responsible for fund debts.
The Limited Partnership Agreement
The limited partnership agreement, or LPA, is the contract that binds everything: the fund’s lifespan, the fee schedule, distribution rules, capital call procedures, restrictions on what the GP may do, and how the fund can be extended or wound down. It is negotiated before any money is committed and governs the fund for its entire life.
Large institutional LPs sometimes sign supplemental side letters that grant them terms better than the base LPA — reduced fees, extra reporting, the right to opt out of specific investments, or priority access to co-investment deals. Side letters often include a most-favored-nations clause allowing the LP to elect any better terms the GP later gives another investor.
How Long Your Money Is Tied Up
A private equity fund has a fixed life, usually about ten years. The first three to five years are the investment period, when the GP is buying companies. The remaining years are the harvest period, when the GP is improving and selling them.
Because the fund is closed-end, you generally cannot withdraw. A secondary market does exist where LPs can sell their fund interests to other investors, but sales typically happen at a discount to reported value. Plan on the money being unavailable for the duration.
Commitments, Capital Calls, and Fees
Commitments and Dry Powder
When you invest, you do not wire the full amount at signing. You sign a binding commitment to contribute up to a specified total over the fund’s life. Until the GP asks for a given tranche, that unspent portion is called dry powder. This lets the fund deploy capital when opportunities appear rather than sitting on idle cash.
The Management Fee
The GP charges an annual management fee to cover salaries, office costs, deal sourcing, and due diligence. The standard rate is 2% of total committed capital. On a $500 million fund, that is $10 million a year. The fee is not tied to performance and is collected regardless of results. During the harvest period, some funds switch the base from committed capital to invested capital, which reduces the fee as companies are sold. Large LPs often negotiate discounts.
Capital Calls
When the GP is ready to buy a company or needs to pay fund expenses, it issues a capital call: a formal notice requiring you to wire your share of the committed capital, usually within 10 to 14 days. Missing a capital call is serious. The LPA typically allows the GP to charge penalty interest, force a sale of your fund interest on terms the GP sets, or even forfeit your existing stake outright.
Subscription Credit Lines
Many GPs borrow short-term against LPs’ unfunded commitments using bank credit facilities called subscription lines. These let the fund close deals quickly without waiting for capital calls to clear. There is a catch when you read performance numbers: by delaying the actual call for LP cash, subscription lines make internal rate of return look better than it otherwise would. One industry analysis showed a fund’s IRR moving from 6.62% to 7.14% just by delaying calls a year, even though the total dollars returned to investors actually fell slightly. Ask whether the IRR you are shown includes or strips out the effect of the credit facility.
What the Fund Does With the Money
Leveraged Buyouts
The dominant strategy is the leveraged buyout, or LBO. The fund acquires a controlling stake in a company using a mix of its own equity and a large amount of borrowed money — debt typically funds 60% to 80% of the purchase price. That debt sits on the acquired company’s balance sheet, not the fund’s, and the company’s own cash flow services it. Leverage magnifies gains when things go well and magnifies distress when cash flow falls short.
Operational Improvements
Because the GP holds control, it can move faster than a public-company board. Typical playbook moves include replacing management, cutting costs, restructuring supply chains, expanding into new markets, and investing in technology to lift productivity. The goal is to grow earnings so the eventual sale price is higher.
Dividend Recapitalizations
A dividend recapitalization has the portfolio company borrow more money and pay the proceeds up to the fund as a dividend. This returns capital to investors before any sale but leaves the company more indebted and more fragile.
Co-Investment
Some LPs negotiate the right to invest in specific deals directly alongside the fund. Co-investments usually carry reduced fees and carried interest, sometimes none. They give the LP concentrated exposure to a favored deal at a lower cost, with correspondingly concentrated risk.
How and When You Get Paid
Cash comes back only when the GP sells companies. Four exit routes are common:
- Initial public offering, where the company lists on a stock exchange. Valuations can be high, but there are regulatory filings, lock-up periods, and market-timing risk.
- Strategic sale to a larger corporation, often a competitor, which may pay a premium for expected cost or revenue synergies.
- Secondary buyout, where another private equity fund buys the company believing it can push further improvement. This is one of the most common exits.
- Continuation vehicle, where the GP transfers a portfolio company from the expiring fund into a new vehicle it also manages. Existing LPs choose whether to cash out or roll in. Because the GP is on both sides, there is a built-in conflict of interest.
The Distribution Waterfall
When cash arrives, it flows through a contractual payment order called the distribution waterfall. The typical sequence: first, LPs get back the capital they contributed. Second, LPs receive a preferred return, usually about 8% annually, as a hurdle the fund must clear before the GP shares in profits. Third, once that hurdle is met, the GP takes carried interest — traditionally 20% of the remaining profits. On $100 million of profit above the hurdle, the GP takes roughly $20 million and LPs take $80 million.
Clawback
Because early exits may pay the GP carry before the fund’s full results are known, LPAs almost always contain a clawback. If the fund’s overall performance falls short and the GP ended up receiving more carry than the final math justifies, the GP must return the excess to LPs, typically at wind-down.
The J-Curve, IRR, and TVPI
Plotted over time, a PE fund’s cumulative returns tend to trace the letter J. In the first few years you are paying management fees and funding capital calls while investments remain unrealized, so returns look negative. As the GP starts selling companies, usually five to eight years in, cash flows back and cumulative returns turn positive. Early red ink is normal, not a warning.
Two numbers dominate performance reporting. IRR, the internal rate of return, is the annualized growth rate of your money weighted by the timing of every cash flow, which is why subscription lines can inflate it. TVPI, total value to paid-in capital, expresses total value received or expected as a multiple of what you put in; 1.8x means $1.80 back for every $1.00 invested. IRR is timing-sensitive, TVPI is not. Read both.
Taxes You Should Expect
Schedule K-1
Because the fund is a partnership, it does not pay tax itself. Income, gains, losses, and deductions flow through to you. Each year the fund sends a Schedule K-1 (Form 1065) showing your share. Partnerships must deliver K-1s by the 15th day of the third month after the fund’s tax year ends — March 15 for a calendar-year fund.4Internal Revenue Service. Publication 509 (2026), Tax Calendars In practice, PE K-1s arrive late or need revisions often enough that filing an extension on your personal return is common.
Carried Interest and the Three-Year Rule (For the GP, Not You)
Under IRC Section 1061, added by the Tax Cuts and Jobs Act for taxable years beginning after December 31, 2017, gain allocated to a GP through carried interest qualifies for long-term capital gains rates only if the underlying asset was held more than three years.5Office of the Law Revision Counsel. 26 U.S. Code 1061 – Partnership Interests Held in Connection With Performance of Services Between one and three years, that gain is recharacterized as short-term and taxed as ordinary income.6Internal Revenue Service. Section 1061 Reporting Guidance FAQs This rule targets the GP’s carried interest. If you are an LP, it does not apply to you; your gains follow standard capital gains rules based on the fund’s actual holding period of each asset.
UBTI in Retirement Accounts
Investing through an IRA, pension, or endowment does not eliminate every tax. Unrelated business taxable income, or UBTI, arises when a tax-exempt investor earns income from activities unrelated to its exempt purpose, and the debt-financed portion of income from a leveraged PE investment can trigger it. When UBTI across a retirement account reaches $1,000 or more, the custodian must file Form 990-T and pay the tax from the account’s cash. The account keeps its exempt status, but your net return drops.
Who Watches the GP
Limited Partner Advisory Committee
Most funds set up a Limited Partner Advisory Committee made up of representatives from the largest LPs. The LPAC does not manage the fund, since that would put its members’ limited liability at risk. It reviews conflicts of interest — for example, when the GP wants the fund to co-invest with another fund it manages, or when a transaction involves a related party — and considers requests to waive specific LPA terms.
SEC Registration
The Dodd-Frank Act removed a prior exemption that let most PE advisers avoid SEC registration. Today, advisers to private funds with $150 million or more in U.S. assets under management generally must register with the SEC under the Investment Advisers Act.7U.S. Securities and Exchange Commission. Private Fund Adviser Overview Registration brings SEC examinations, disclosure of conflicts on Form ADV, and recordkeeping obligations. If you are considering a fund, you can look up its Form ADV before committing.