To understand what a private equity firm is, it is important to understand what the different parts of the term mean. Equity is the value of an asset less any associated liability. Private equity is the equity in an asset that isn't freely tradeable on the public stock market. A private equity firm, then, is the controlling partner in a collection of partnerships that have come together to pool their capital and invest in a particular opportunity.

While private equity firms may focus on a variety of investment strategies, including drumming up venture capital, they often buy undervalued or under-appreciated companies, improve them, and then sell them for a profit, sort of like house flipping but in a commercial setting. After buying a company, a private equity firm will remove it from the stock market. This allows the firm to make tough or controversial decisions without having to answer to or release sensitive information to shareholders or the public generally. By making the company private, the private equity firm is basically only accountable to its smaller group of investors.

In order to turn the company around, a private equity firm will often replace or control the management team of the company. It isn't unusual, however, for the equity firm to keep existing employees of an existing company. While the equity firm is controlling the company, it's goal is usually to determine how it can improve the company's performance or projected future performance so that potential investors will buy the company at a profit.

Private equity funding can come from a variety of sources. Most often, the funds come from pension funds, financial institutions, or individual investors with a substantial net worth. By being able to pool such large amounts of investment capital, the private equity firm expands its reach to, and power over, potential investment opportunities.

Once the work of improving the company has been done and its value increased, sometimes in as little as three years, the private equity firm takes the company public again. If it all works out, the firm sells the company for a nice profit for all original investors. The private equity firm itself, also called the general partner of the partnership of investors, also often draws additional fees, including management and performance fees, for the legwork involved in the endeavor, including advertising, accounting, and the like.