The J-Curve in Private Equity and How To Beat It
Private Equity (PE) is an asset class with various unique benefits. It can offer a safe haven during market volatility and give exposure to growth opportunities during recessions.
One important difference - compared with regular investments - is the trajectory of returns.
In a publicly-traded security, one can expect to achieve returns from the beginning (i.e. through price appreciation or dividends). In private equity, returns are often delayed for some years, a phenomenon known as the J-curve.
What is the J-curve?
When one invests money in a PE fund, the fund will start to conduct due diligence on the most promising opportunities (deal sourcing). It normally takes some years to acquire a portfolio of companies.
Furthermore, when a company is acquired, this is followed by a period of transformation (value creation).
The bulk of the returns will arrive when a company is sold, 5-8 years after the initial acquisition.
What does all this mean for one’s returns? The answer is contained in the diagram below.
The “J” refers to the slope of returns, which decline initially and then trend gradually upward.
Initial returns are negative because investors are contributing capital and paying management fees. Meanwhile, the sale of the company is still years away.
This is why PE uses multi-year metrics (e.g., IRR, MOIC) to describe returns. instead of the more familiar annualized rates of return (e.g., Return on Equity).
How can we mitigate the J-curve?
Strategy 1: Building a portfolio of funds
If one invests in multiple funds, the returns from more mature funds may offset the negative returns from newer funds. An alternative could be to take over positions in mature funds from investors who wish to sell their stake via secondary markets.
The minimum investment requirements for investing in a fund are normally high. As a result, this strategy may not be feasible for most investors. Furthermore, the time needed to accumulate multiple positions may defeat the initial purpose.
Strategy 2: Co-investing
Co-investing is when you invest alongside (not through) a PE fund. Co-investing takes place for a specific investment. As a co-investor, you can scrutinize the deal, and maintain visibility and influence throughout the deal’s lifetime.
This change in the relationship helps to address the J-curve problem in various ways:
Faster returns: because 100% of an investor’s capital is used up-front, there is no lag time. BlackRock estimates that a modest allocation to co-investments can decrease the J-curve by 12-18 months.[1] Since the investor has control, it is also possible to focus on deals with a faster turnaround time.
Lower fees: Standard PE fees consist of a 2.0% management fee and a 20% share of the profits (“carried interest”). Co-investors enjoy lower fees, which mitigates negative returns and maximizes eventual profits.[2] Some funds will even waive fees entirely for co-investors.
Co-investing also allows investors to get a closer look at the processes of the PE funds they work with. The choice of acquisition also allows them to be precise in diversifying their broader portfolio.
What can be done
Co-investing is an effective strategy, but it carries heavier obligations.
The fees are lower for a good reason. By allowing one to co-invest, the PE fund is shifting some of the risk onto his shoulders.
To mitigate this risk, one must be prepared to do his share of due diligence. This requires time, expertise, and additional support (e.g., one’s own legal team). Certain obligations will also be ongoing (e.g., board meetings) as well as a need to interact with fellow investors on a regular basis.
At Petiole, we believe that top-tier strategies and opportunities should be open to all qualified investors. That’s why we don’t simply provide our clients with access to co-investing opportunities. We also support them through the process, using technology to remove friction and improve transparency.
Get in touch with one of our associates to find out what we can do for you.
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