On one level, J curves are easy to understand. A J curve simply refers to a line graph which forms the shape of the letter J, initially dropping into negative territory before shooting back up sharply into the positive range. J curves appear in fields ranging from private equity to economics to medicine. These sorts of graphs represent a situation where a downturn is immediately followed by a positive surge. This can seem like a contradiction—a decline preceding substantial growth—but it’s part of the normal functioning of a private equity fund.
When a private equity fund launches, it typically has several years of negative returns as it fills its portfolio. This early stage of negative internal rates of return (IRR) is the drop in the J curve. It can also be the highest risk period for investors. There are several reasons this decline happens; private equity funds generally lose money at the beginning because they are investing in companies and paying fees. In the early years of a fund, underperforming investments are more likely to be written off as well. In basic terms, the fund’s money is going out, but there isn’t anything coming back in—yet. It takes time for these sorts of investments to mature. Of course, investing funds in companies is the entire point of private equity, so J curves are supposed to happen, although they can be disconcerting for newcomers to the field.
Eventually, if everything goes according to plan, the downward trend begins to reverse, and then shoot up (completing the J). This rapid increase happens once the fund starts to mature and portfolio companies begin to generate returns. As cashflow improves, private equity firms typically pay down debt, then begin returning cash to investors.
Generally, a well-managed firm will have a strong J curve, shooting up at a steep angle after a few years of losses—meaning that they generated high returns in a short period of time—while less successful funds will have a much shallower J curve. The worst performing funds may never make it out of that slump, hence the reason the downturn at the beginning of the J curve carries increased risk.
While the J curve has been a normal aspect of private equity investing for decades, in recent years there have been efforts to mitigate the period of early losses. Fund managers have worked to smooth out their early years of investing by using low interest credit to improve their internal rate of return (IRR) and implementing management fee offsets to keep more of their invested funds inside of portfolio companies. While funds that do a better job at preventing these early losses may have a much shallower period of losses in their J curves, the steepness of the rise in the graph is still a good indication of whether the fund managers are doing a good job.
When private equity funds are created, investors inject money in stages. “There may be multiple closes in between each of these stages,” says Accrete Founding Partner and CEO Ali Shekofti. “But there is one thing to keep in mind whenever you’re allocating funds, and that’s what you call blind pool risk.” Blind pool risk exists when investors make a commitment early on in the life of the fund, before they know what the underlying investments will be. While the fund’s managers typically believe they’ll be good investments, no one really knows yet. The later in the cycle investors enter funds, the less risk there is, because they know what sorts of plays the fund managers will be making.
Accrete uses several strategies to mitigate the risk present early in the life-cycle of funds. Accrete typically does not commit to a fund until after it has closed its first one or two underlying transactions, which diminishes blind pool risk. “By the time that investors are committing to us, we have a really good view of essentially what the underlying portfolio is,” Shekofti says. Not only that, but by entering at a later close, Accrete is typically following institutional money; the big money is already committed.
Many institutional players, however, enter funds very early because they receive more favorable fee structures for being first money. Typically, investors who enter at a later close pay an equalization fee, essentially compensating early participants for the greater risk they took on, as well as greater management fees. Accrete avoids high equalization and management fees by developing close relationships with sponsor partners and by using a co-investment model. And Accrete further reduces fees for its investors by discounting its own fees relative to those being charged by feeder funds.
J curves are a great tool investors can use to evaluate the performance of funds and fund managers. While J curves don’t tell the whole story, of course, they can provide a quick, reliable snapshot of a fund.