Private Equity’s J-Curve and Its Mitigation
Within private equity, a fund’s returns often resemble a J-Curve where there exists a small loss before a continued gain. This image would resemble a “J” when charted. This is especially common for private equity firms that purchase struggling companies and attempt to turn them around. These firms will take on unprofitable businesses, and tag along management fees that keep investor returns low or negative until their investments begin to mature, and the purchased businesses become profitable. This creates a period wherein traditional private equity investment is unprofitable and returns are low, or the dip at the beginning of the “J”. These cash flows depend on the “timing of cash flows, timing of performance, and market performance” (Diller, 20). By pulling these levers one way or another, the J-curve can be manipulated. With research indicating that funds with at least 15% private investment outperform their peers, the benefits of seeking these investments are clear. But how can we reduce the time in which these investments underperform?
To capture the returns of private investment while avoiding severe beginning losses, we can turn to secondary investments and co-investments. Secondary investments allow investors to exchange ownership outside of the issuing company. While a company may issue ownership shares through either a public offering or private funding round, a secondary exchange is the transfer of that ownership between investors afterward. As secondary investments tend to be more mature investments, they tend to be faster to distribute back to shareholders. For instance, a secondary investment may be the purchase of a company that has since developed and grown since its earlier funding, and the original investor is looking for an exit or needs liquidity. As a result of this, we can see a comparison of cash flows between a secondary fund, a more mature secondary fund, and a primary fund of funds (FoF) in the chart below.
As we can see from this figure produced by Capital Dynamics, secondary funds are able to generate positive returns much faster than traditional FoFs, and as a result have a much shorter period of negative returns. While they reach their bottom in negative earnings faster, they generate a significantly higher overall return. Since the investment returns are generated much sooner, liquidity for investors is also freed up much earlier. This liquidity is valuable in the private industry that tends to generate its higher returns from these extended periods of illiquidity. Secondary investments are not the only method we can use to mitigate early losses, however. Co-investments are also highly effective at cutting down on early losses, and reaching profitability faster.
Co-investments allow investors to take on a minority investment alongside a PE firm. This type of investment often occurs when a large PE firm is running low on available funds and doesn't want to pass up a potential investment. Due to this relationship a co-investment “provides a less expensive fee structure compared to traditional private equity funds” (Co-Investing, 2). As co-investors are able to join in these investments near the time of purchase, as opposed to a traditional PE fund in which investors join often during or before the search, co-investors skip much of the waiting. They are also able to avoid much of the management fees that PE firms charge. This combines to deliver co-investors a higher-than-average return on these investments than they would under the traditional PE firm. As we can see from the illustration below created by HarbourVest, a co-investment fund is able to mitigate early losses and outperform a traditional fund in the long-term due to their reduced fee structure.
While certainly appealing, a co-investment is not always an easy deal to come by. It requires an established relationship with an existing PE firm to be offered a co-investment, and as such often only established funds are offered co-investment options. This may make it difficult for new firms to seek out these co-investments, yet established wealth management firms often may have these relationships garnered over the years.
Traditional Fund of Funds and their early losses, while they may be here to stay, can be beaten on returns with secondary investments and co-investments. Each is able to partially mitigate early losses that are common in FoFs, and deliver returns faster. Both with lower fees and faster maturity, these investments could yield a highly competitive return compared to traditional FoFs. Of course, as with any investments their returns are volatile and should be evaluated on a case-by-case basis.
Works Cited
“Co-Investing 101: Benefits and Risks.” Harbourvest.com, pages.harbourvest.com/rs/509-TRI-465/images/PMI-2017-02-CO-INVEST.pdf.
Diller, Christian, Ivan Herger, and Marco Wulff. "The private equity J-Curve: cash flow considerations from primary and secondary points of view." Capital Dynamics (2009): 1-10.
