The J-Curve in Private Equity—and How to Potentially Beat It

Executive summary:

The J-curve is a term commonly used in private markets to describe the tendency for investors in closed-end funds to experience negative returns in the early years of a fund’s life, particularly with primary (newly formed) fund investments.
Secondary funds can help diminish the initial J-curve of a private markets portfolio and offer cash back more quickly to private markets investors.
Partnering with firms that have the requisite scale and demonstrated access to top-tier investment opportunities is one way investors can potentially eliminate the J-curve in a private markets investment program.

Investor interest and participation in private markets continues to grow. Investors are attracted to private markets for different reasons, including access to the significant investable opportunity set that exists across the universe of private companies along with the potential for greater returns and lower volatility relative to the public markets. Implementing a successful private markets program as part of a total portfolio is not without some implementation challenges, however, and perhaps the most pressing issue investors face which needs to be solved for is managing the J-curve.

What is the J-curve?

In private markets, the J-curve is the term commonly used to describe the tendency for investors in closed-end funds to experience negative returns in the early years of a fund’s life, particularly with primary (newly formed) fund investments. This occurs because capital commitments take several years to be called, yet fees are charged (on committed capital) prior to the realization of returns, such as distributions or the sale of portfolio company investments. And while the J-curve reverses over time as investments are made, the fund’s net asset value grows and investments are realized, investors are nonetheless exposed to negative returns in those early years. In this article, we’ll discuss strategies that can be used to potentially eliminate the J-curve in a private markets investment program, resulting in improved investment outcomes.

As investors implement their desired strategic asset allocation targets to private markets, a key component of their portfolio construction toolkit is the use of secondary (purchase of existing interests in private markets funds) and co-investment strategies (investments directly into portfolio companies). By allocating a meaningful component of portfolios to secondaries and co-investments, investors’ capital commitments can be called more quickly and returned faster, ultimately allowing their private markets portfolios to enjoy positive performance very early on.

What is the secondary market?

The secondary market involves the buying and selling of pre-existing investor commitments to private markets funds. Secondary funds, in turn, can buy either from the investment managers (general partners or GPs) or those investing into their funds (limited partners or LPs). As secondary interests are comprised of existing portfolio company investments, they are more mature in their lifecycle when compared to primary fund investments.

How secondary funds can help diminish the J-curve—and return cash to investors quicker

The more developed nature of the underlying investments offers a host of additional benefits to the investors in secondary funds. As noted earlier, when the typical private markets fund begins to invest, early cash outflows typically lead to a J-curve, or initial negative performance early in the fund’s life. This can be particularly daunting for newer entrants building out their first private markets portfolio. Without distributions from longer-tenured funds, years of negative and/or low returns would face the new private markets investor. Including secondary funds in the mix can optimize portfolio construction. By entering later in an investment lifecycle, and therefore closer to or during achievement of value accretion, such an initial dip is lessened in secondaries funds. In other words, by shortening the length and/or lowering the depth of the outflows and hastening inflows, secondary funds can diminish the initial J-curve of a private markets portfolio and offer cash back more quickly to the private markets investor.

The more advanced stages of investments within a secondary fund can also translate to shorter timelines to exit for the underlying assets, and therefore shorter tenures for the secondary funds relative to a primary allocation. Secondary funds can therefore offer entrance into otherwise longer-dated strategies for investors with timeline constraints.

What are other potential benefits of secondaries?

Other potential benefits of secondaries include reducing blind pool risk and the potential to purchase assets at discounts to net asset value.

Another key benefit of secondaries investing is reducing blind pool risk. When investors commit to primary funds, they don’t know in advance what investments the GP will make. In contrast, secondary funds invest in existing commitments and are able to conduct due diligence on these assets prior to investing. With this greater transparency into the underlying assets comes greater visibility into potential future performance, including near-term exits, pending asset write-ups and positive inflection points. These all contribute to improving near-term performance outcomes for investors.

In addition, secondary investments benefit from pricing dynamics unique to the space: discounts. Purchasing a secondary interest at discount to its net asset value can provide an early mark-to-market gain for secondary funds and a cushion against the typical J-curve impact. However, the availability of discounts depends on a variety of factors, ranging from the particularities of the seller’s circumstances, to the quality of the assets and sponsors, to the relevant market environment, among other considerations.

What are co-investments?

Co-investments are direct investments into a portfolio company alongside a general partner. As such, co-investments accelerate the deployment of capital—because when an investment is made in an underlying portfolio company, 100% of a limited partner’s commitment is called up-front. In addition, co-investments are typically made on a no-fee, no-carry basis, which represents an extremely cost-effective way to participate in high-quality deals alongside high-quality general partners outside of the primary fund construct. This combination of deploying capital faster and averaging down on fees is an efficient way to reduce both the length and depth of the J-curve.

The bottom line

As investors implement their desired strategic asset allocation targets to private markets, a key issue to address is managing the J-curve. By partnering with firms that have the requisite scale and demonstrated access to top-tier investment opportunities, along with specialist investment and portfolio management expertise in areas such as secondaries and co-investments, investors can potentially eliminate the J-curve in a private markets investments program, resulting in improved investment outcomes.

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

The Russell logo is a trademark and service mark of Russell Investments.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.

In general, alternative investments involve a high degree of risk, including potential loss of principal; can be highly illiquid and can charge higher fees than other investments. Hedge strategies and private capital investments are not subject to the same regulator requirements as registered investment products. Hedge strategies often engage in leveraging and other speculative investment practices that may increase the risk of investment loss.

A message from Advisor Perspectives and VettaFi: Join us on June 27 for the Midyear Market Outlook Symposium, where advisors will gain insights into macroeconomic trends, active ETFs, investing abroad, and more to navigate 2024's challenges.