Understanding the J-curve in private markets

What You’ll Read

• What is the J-curve in private markets?
• Factors that influence the J curve 
• How secondaries can help investors mitigate the J curve effects

Key Takeaways

• The “J curve” in private markets refers to the shape of investment performance — IRR, or the internal rate of return — in closed-end funds.
• The J-curve is broken down into three sections: periods of capital calls, investment, and harvesting.
• The shape of the J-curve can be influenced by factors such as the type of asset class, timeline of capital calls, and exit strategy.
• Secondary opportunities may offer investors a way to mitigate the early years of the J-curve. 

The investment performance of venture capital and private equity funds is often irregular. In the early years, the fund will deploy capital and draw down management fees, and only years later will funds begin to realize mark-ups or distributions from portfolio company exits. 

This non-linear performance is referred to as the “J-curve” and can impact how investors think about allocating capital to private market funds. 

What is a “J-curve” in private markets

The “J curve” in private markets refers to the shape of investment performance—IRR, or the internal rate of return—in closed-end funds. Investment performance in private market funds is generally broken down into three sections: periods of capital calls, investment, and harvesting. These three periods define the J curve across both venture capital and private equity funds—albeit in slightly different forms—and have meaningful implications for the investor experience and investment return scenarios. 

Capital call period 

During the initial years of a fund’s lifespan, the fund manager, or General Partner (GP), calls capital from their LPs and deploys the capital into deals. At the same time, the GP is also earning management fees, since LPs pay management fees based on the total amount of committed capital and not invested capital. From the LP’s perspective, cash outlays are negative in these early years. Investments in private companies can take years to bear fruit, meaning in the first few years of a fund’s life, capital is being deployed while usually no capital is being returned to investors yet.

Investment period

In years 4-6 of the fund’s life, the fund’s underlying portfolio companies begin to grow in value resulting in unrealized gains for the fund and its LPs. Some portfolio companies may also be exited, leading to cash distributions. On the J curve, this time period is illustrated by a sharp increase in unrealized IRR by markup valuations. 

Harvesting period

The last few years of a fund’s lifespan—typically years 7-10—are marked by the majority of the underlying portfolio companies being exited. In the harvesting period, the fund manager is seeking to maximize investor returns. As each investment is exited, the manager becomes closer to realizing the fund’s investments, making this part of the J curve flatten out from an IRR perspective.

Factors that influence the J curve 

General partners operate their funds in different ways that can impact an LP’s IRR over time—the shape of the J curve.

• Capital calls: The speed at which the manager calls capital and deploys the capital into investment opportunities will change the shape of the J curve. Faster deploying of capital will result in a steeper descension of the initial J curve, while slower calling and deploying of LP capital will result in a more gradual downward slope. 
• Value creation: The success of the manager’s investment thesis and ability to enhance the value of a portfolio company shows in the shape of the J curve. Value creation is also spread out differently based on the investment period. Some growth happens quickly, like in the case of a leveraged buyout, while other investments take time to mature, like long-term venture-backed companies. 
• Exits: Private market fund managers have investment theses that are different. In blue chip private equity, a manager might target exits in 3-5 years, while in venture capital, exits might be targeted in 7-10 years. A manager’s thesis will determine the target exit timeline. 
• Market conditions: Macroeconomic conditions like interest rates, investor sentiment, and consumer spending all impact the performance of portfolio companies, and a manager’s willingness to call and deploy capital. These market conditions impact the timeline for an LP’s cash inflows and outflows.  

How secondaries can help investors mitigate the J curve effects

So what can investors do to avoid the early years of the J curve? 

Investors can participate in secondary transactions as a way of “buying in” to a fund’s performance further down the lifecycle. 

Secondary opportunities are attractive to investors because:

• Investors can buy into a fund’s partnership, potentially at a discount to its net asset value (NAV) depending on the circumstance. 
• Investors are more likely to receive cash inflows faster than if they committed to the fund when it was starting. Some funds may already be distributing cash to their investors at this point in the lifecycle. 
• Investors have more clarity into the fund’s portfolio companies, rather than investing in a “blind pool” fund. 
• Portfolio company performance has had time to show itself, allowing investors to see which companies have shown signs of early success. This lowers the company-specific (alpha) risk involved in investing in the private markets (notably, this also lowers the potential return compared to investing at the earlier stages). 

How Zest Can Help

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