Private equity is an asset class consisting of equity securities in operating companies that are not public traded. Private equity funds are faced with high return expectations by their investors that only few in the industry can meet. How do private equity funds create value?

1. Private equity funds usually challenge the way the businesses are run and improve operations of these businesses. Although some of very best private equity firms have developed effective re-engineering capabilities to add value to their investments and generate superior returns, this is not the main driver of value creation.

2. FA business's financing can be improved since many private equity firms have better access to credit markets. Some of them can use the tax shield on the acquisition debt to create value.

3. Incentivizing management. Incentives that motivate managers to "behave like owners" are at the heart of PE value proposition. Having the right people in place is critical to success. PE investors retain senior managers capable of driving value growth and replace those not up to the task. Incentives between investors and management are fully aligned.

4. Effective contractual structuring of the investment is also a source of value creation in private equity.