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FRM Exam Part I · Fund Management

Private Equity and Venture Capital Basics for FRM Part I

Updated 11 October 2026 · Fact-checked

Private equity funds raise capital from investors (LPs), which a manager (GP) invests in private companies. Buyout funds use heavy debt to acquire mature firms. Venture capital funds back young firms with equity. The GP earns a management fee on committed capital plus carried interest, typically 20% of profits above a hurdle.

Understand Private Equity and Venture Capital Basics

Private equity (PE) means equity investment in companies that are not listed on a public exchange. Investors, called limited partners (LPs), commit capital to a fund run by a general partner (GP). The GP finds deals, manages the companies and sells them, usually within about ten years. The fund is a partnership, so LPs cannot easily sell out. These investments are illiquid, and returns are reported with a lag.

A leveraged buyout (LBO) is the main buyout strategy. The fund buys a mature company using a small amount of its own equity and a large amount of borrowed money. The target's own assets and cash flows back the debt. Cash flow pays down the debt over time. If the company is later sold or floated for more than its cost, the equity gains are magnified by the leverage. The risk is also magnified: if earnings fall, the debt can wipe out the equity.

Venture capital (VC) is a branch of PE that backs young, high-growth firms. Stages run roughly like this: seed (idea and prototype), early stage (first product and launch), expansion or later stage (scaling up), and mezzanine or bridge financing before an exit. VC uses little or no debt, because young firms have no stable cash flow. Many investments fail, and a few big winners drive the fund's return. Exits come through an IPO, a sale to another firm, or a sale to another fund.

Fund economics are a favourite exam area. The GP charges a management fee, often about 2% a year, on committed or invested capital. It also takes carried interest (carry), often 20% of profits. A hurdle rate (preferred return), often around 8%, must be earned by LPs before carry is paid. A catch-up lets the GP then receive a larger share until it holds its full share of total profits. A clawback makes the GP return excess carry if later losses mean it was overpaid. Capital is called from LPs over time through drawdowns, so cash flows are uneven and the usual performance measures are IRR and the multiple of invested capital.

Key formulas to remember

Management fee
Fee = fee rate × fee base (committed or invested capital)
Check the base stated in the question. Committed and invested capital give different fees.
Carried interest (no hurdle)
Carry = carry rate × fund profit
Profit is usually measured after returning contributed capital and, in some deals, fees.
Carry with hurdle and no catch-up
Carry = carry rate × (profit − hurdle amount), if profit exceeds the hurdle
Without catch-up, the GP shares only in profit above the hurdle.
Carry with full catch-up
Carry = carry rate × total profit, if profit is large enough to complete the catch-up
With full catch-up the GP receives 100% of profit above the hurdle until it holds the carry rate of total profit.
Multiple of invested capital
MOIC = total value returned ÷ capital invested
Ignores timing. IRR does consider timing.
LBO equity share
Equity = purchase price − debt
Debt-to-price ratio shows leverage. Equity return = (exit value − debt remaining − equity) ÷ equity.

How to solve Private Equity and Venture Capital Basics questions

Use this method for fee, carry and LBO questions, and for qualitative questions on PE and VC.

  1. 1Identify the party and the structure: LP or GP, buyout or venture, and the stage of the company.
  2. 2Write down the terms given: fee rate and base, carry rate, hurdle, catch-up, clawback.
  3. 3Compute the fee first using the stated base and the number of years.
  4. 4Find fund profit: total proceeds minus capital returned (and fees if the question says so).
  5. 5Apply the waterfall in order: return of capital, hurdle, catch-up if any, then the carry split.
  6. 6For an LBO, compute equity as price minus debt, then debt remaining at exit, then equity value at exit and the return.
  7. 7Check that the LP and GP amounts add up to total proceeds, and that the answer matches the question's units.

Quickest way: Waterfall shortcut

When to use it: Use when a question gives a hurdle and asks for the GP's carry in a numeric multiple-choice item.

  1. Ask first: is there a catch-up? If yes and profit is large, carry is simply carry rate × total profit.
  2. If no catch-up, carry is carry rate × (profit − hurdle amount).
  3. Compute the hurdle amount as hurdle rate × capital × years, unless compounding is stated.
  4. Eliminate options that give carry greater than carry rate × total profit. No standard structure pays more.

Common mistakes in Private Equity and Venture Capital Basics

  • Charging carry on all profit when the fund has a hurdle and no catch-up.

    Students remember '20% of profits' and skip the hurdle.

    Fix: Read for the words hurdle, preferred return and catch-up before computing.

  • Applying the management fee to the wrong base.

    Fees can be on committed capital or invested capital, and students assume one.

    Fix: Use the base stated in the question. Default to committed capital only if told.

  • Confusing venture capital with buyouts, for example saying VC uses heavy leverage.

    Both are called private equity.

    Fix: Link buyouts to mature firms and high debt, and VC to young firms, equity funding and high failure rates.

  • Treating clawback as a GP fee.

    The word sounds like a charge.

    Fix: Clawback protects LPs. The GP returns excess carry if the final result does not justify what it was paid.

  • Treating reported PE returns as comparable with listed-market returns without adjustment.

    Students ignore smoothed valuations and illiquidity.

    Fix: Remember that PE valuations are appraisal-based and stale, which understates volatility and correlation, and that illiquidity needs a premium.

Worked examples

Example 1

A PE fund has $200 million of committed capital and charges a 2% annual management fee on committed capital. Over its life it returns total proceeds of $360 million to the partnership after 5 years of investing. Ignore fees when measuring profit. Carry is 20% with an 8% simple annual hurdle on $200 million, no catch-up. Find the GP's carry.

Show the solution
  1. Profit = 360 − 200 = $160 million.
  2. Hurdle amount = 8% × 200 × 5 = $80 million.
  3. No catch-up, so carry applies only to profit above the hurdle: 160 − 80 = $80 million.
  4. Carry = 20% × 80 = $16 million.

Answer: $16 million

Example 2

A buyout fund buys a company for $500 million using $400 million of debt. After 4 years, the company is sold for $650 million and $300 million of debt remains. What is the equity multiple (MOIC) of the fund's investment?

Show the solution
  1. Equity invested = 500 − 400 = $100 million.
  2. Equity value at exit = 650 − 300 = $350 million.
  3. MOIC = 350 ÷ 100 = 3.5.

Answer: 3.5 times

Exam tips

  • Read the waterfall terms carefully. Hurdle, catch-up and clawback change the answer.
  • Expect conceptual questions on why LBO targets are mature firms with stable cash flow, and why VC returns are skewed to a few winners.
  • Link illiquidity and appraisal-based valuation to understated volatility and biased performance measures.
  • Do the arithmetic in millions and check that LP plus GP shares equal total proceeds.

Practice questions from Fund Management

Private Equity and Venture Capital Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Private Equity and Venture Capital Basics: frequently asked questions

What is the difference between private equity and venture capital?

Venture capital is a type of private equity. Buyout funds acquire mature firms, often with heavy debt. VC funds invest equity in young, high-growth firms with little or no debt.

How does a leveraged buyout work?

A fund buys a company using a small amount of equity and a large amount of borrowed money secured on the target. Cash flow repays the debt. Leverage magnifies gains if the exit price is high and losses if it is not.

What is carried interest?

Carry is the GP's share of fund profits, commonly 20%. It is often paid only after LPs receive a hurdle return, and a clawback may require the GP to return overpaid carry.

What does a catch-up do?

After the hurdle is met, a catch-up directs extra profit to the GP until the GP holds its full carry share of total profit. With a full catch-up, carry ends up as the carry rate times total profit.