Private equity (PE) firms are financial powerhouses—but how exactly do they make money? Understanding the mechanics behind PE is crucial for essential services business owners considering a sale.
1. Management Fees & Carried Interest
PE firms raise capital from Limited Partners (LPs)—institutional investors like universities, pensions, family offices, and endowments. In return, LPs typically pay:
• 2% annual management fee on committed capital
• 20% of profits as ‘carried interest
This model incentivizes PE firms to invest capital quickly and profitably—usually by acquiring and scaling businesses.
2. Value Creation through EBITDA Arbitrage
Another major source of PE profit is through a tactic called EBITDA arbitrage. This means buying a smaller business at a lower EBITDA multiple and integrating it into a larger platform valued at
a higher multiple. Example:
A platform HVAC business has
• $50M in revenue
• $10M EBITDA
• Valued at 15x EBITDA = $150M Enterprise Value
It acquires a smaller HVAC company with
• $5M in revenue
• $1M EBITDA
• Purchased at 10x EBITDA = $10M EV
After acquisition
• Operational improvements increase EBITDA to $1.5M
• At 15x multiple, new valuation = $22.5M
• Instant value creation = $12.5M gain
This strategy allows PE firms to generate outsized returns quickly—making well-run essential services businesses extremely attractive acquisition targets.
