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Industry Voices

Commentary: Death of the J-curve

Arthur Miller's 1949 play "Death of a Salesman" focuses on the deterioration and ultimate demise of its main character, Willy Loman. While there are several contributing factors to his death, primary among those are Willy's hallucinations of an idyllic past that are in sharp contrast to his progressively problematic reality. Similar to Willy Loman, a fundamental aspect of private equity, the so-called J-curve, is undergoing significant decline due to numerous factors. The confusion induced by the J-curve might soon be alleviated; not through better education or a broader understanding of the asset class, but by several developments that are leading to the actual demise of the J-curve.

A graph of a private equity fund's internal rate of return vs. time starts at zero IRR in year zero and then drops into negative territory before reversing and going upward in the fund's later years, thereby forming the letter J. For those unfamiliar with the asset class, the immediate foray into the negative return region is particularly concerning. The J-curve phenomenon is caused by three aspects that are endemic to investments in private equity funds:

1. Capital is called over time.

2. There is a lack of market valuation.

3. Rees create a drag on returns.

Most private equity funds have a multiyear investment period over which they source, evaluate, negotiate and ultimately invest in their portfolio companies. Traditionally, an investment is carried at cost for at least several quarters and the valuation is not changed until later in the company's life. Once the fund is activated, management fees are periodically drawn, typically quarterly, independently of the investment pace. As the full amount of capital has not been drawn, and fees are based on committed and not invested capital, the initial fees appear disproportionately large relative to invested capital.

However, several recent developments might be leading to the end of, or at least the significant diminishment, of the J-curve. Some of these developments are structural changes, while others are due to the growing appreciation by private equity fund managers of the importance of IRR to institutional investors. Despite well-documented issues in applying IRR measures to private equity investments, many institutional investors continue to use IRR as the primary performance and compensation benchmark. A practice that is becoming more common is for a fund manager to raise a fund, but not activate it until at least one investment has been made. This is known as warehousing. As the fees are measured against an existing asset base and, all else equal, the time between when the capital is called and the first increase in valuation is shortened, the IRR is improved.

Another practice that fund managers have been employing more aggressively is using credit lines to smooth out or delay capital calls. In some cases, fund managers have shifted their capital calls by as much as six months. This has been an especially attractive technique for fund managers in the current low-interest-rate environment. Similar to warehousing, using credit lines shortens the time between the capital call and any increase in portfolio company valuation. By using low-interest credit lines, fund managers can substantially improve IRR and do so at a relatively low cost to the fund.

One structural development that is affecting the J-curve is the adoption of fair-market valuation as specified by the Financial Accounting Standard Board's Statement 157. As auditors have gained experience with this regulation, it is more common for them to be active in the valuation discussion with private equity fund managers, especially for the fund's year-end valuation reports. It is much more common now to see investments written up over shorter periods of time than previously. The increase in portfolio company valuation can more than offset the drag on returns created by the fees, particularly as IRR is very sensitive to small valuation changes over short time periods.

A second structural aspect that is affecting the J-curve is the increasing use of management fee offsets. Private equity funds often receive income from portfolio companies for services rendered, such as participating on the company's board of directors. Investors in private equity became more aware of this practice and realized that, in effect, part of their investment flowed through the fund into the portfolio company and then directly back to the private equity fund managers. Most funds now either offset the entire income or at least a substantial portion of it. As a result, the fees called from the private equity fund investors have decreased, thereby diminishing the fee drag and improving IRR.

It is notable that of the four issues discussed above, all are functioning in the same direction — to diminish the J-curve effect. For a specific fund, the degree to which each factor affects the J-curve is largely dependent on decisions made by that fund's managers. However, as fund managers are competing against their peers and IRR remains an important benchmark to institutional investors, there are clear incentives to use any available methods to improve competitive positioning. This will almost certainly result in significant diminishment or, possibly, the elimination of the J-curve across the industry.

In "Death of a Salesman," Willy Loman's tragedy was primarily driven by the increasing divergence between reality and his perceptions of it. In contrast, the death of the J-curve is due, in part, to improvement in the measurement of returns (i.e., perception) relative to reality. Unlike in the final scene after Willy's death, it is doubtful that few, if any, tears will be shed for the J-curve's demise. It is far more likely that portfolio managers will eagerly anticipate the day when they don't have to defend the perception of negative returns in the early years of a private equity fund investment.

William Charlton is managing director and head of global research and analytics at Pavilion Alternatives Group LLC, Richmond, Va. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.