How a PE fund makes money
By SuperdayReps · Michigan Ross Undergrad | Wharton MBA · ex-Citi | ex-Greenhill · Former Head Mentor at a Leading IB Prep Service
9 min read · updated October 14, 2026
A private equity firm does not mostly invest its own money. It raises a fund from outside investors, buys companies with that fund, and gets paid in two ways for doing it. If you understand those two ways, a lot of sponsor behavior that looks strange from the outside starts to make sense.
The players and the fund
Every fund has two kinds of partner.
- The general partner (GP) is the PE firm. It finds the deals, runs the portfolio, decides when to sell, and carries legal responsibility for the fund. The GP usually puts in some of its own money too, often 1 to 3% of the fund, so it has skin in the game.
- The limited partners (LPs) are the investors who supply nearly all the money: pension funds, university endowments, sovereign wealth funds, insurance companies, family offices. They are "limited" because they have no say in individual deals and can lose no more than they put in.
When an LP joins a fund it makes a commitment: a promise to provide up to a fixed amount, say $50 million, over the life of the fund. It does not wire the money on day one. The GP calls it as needed through capital calls, also called drawdowns, typically when it has a deal to fund or fees to pay. Committed money not yet called is the fund's dry powder.
A typical fund lives about ten years. The first four or five are the investment period, when the GP buys companies. The rest is the harvest: growing the companies and selling them. As each deal exits, the cash goes back to the LPs, minus the GP's share.
The LPs pay to be in the fund before they see any gain, because fees are called from day one and good exits take years. So an LP's cumulative return is negative early in the fund's life and only turns up later. Plotted over time, that dip and recovery is called the J-curve.
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Frequently asked
- How does a private equity firm make money?
- Two ways. A management fee, usually 1.5 to 2% a year, paid on the fund's committed or invested capital whether deals do well or not. And carried interest, usually 20% of the fund's profits, paid only after investors have their money back plus a hurdle return. The fee keeps the lights on; the carry is where partners get rich.
- What is carried interest?
- Carried interest is the general partner's share of the fund's profits, typically 20%. It is paid only once the limited partners have received back all the capital they contributed plus a preferred return, often 8% a year. If the fund does not clear that bar, the general partner earns no carry at all.
- What is a hurdle rate and a catch-up?
- The hurdle, or preferred return, is the return investors must receive before the general partner earns any carry, commonly 8% a year compounded. The catch-up is the stage right after the hurdle where most or all of the next distributions go to the general partner until it has received its full 20% of total profits.
- Why is net IRR lower than gross IRR?
- Gross IRR is the return on the deals themselves. Net IRR is what investors actually receive after management fees, fund expenses and carried interest come out. Fees shrink the money that gets invested and carry takes a slice of the profit, so a typical gap is several percentage points.
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