The J-curve is one of the key factors that makes investing in private equity and venture capital funds fundamentally different than investing in public stocks. Understanding the J-curve and it's impact is important as a Limited Partner in a fund.
What is the J-curve
The J-curve refers to the initial decline followed by a subsequent rise in the value that is common of a PE or VC fund. This typically occurs because private equity investments require time and capital to achieve growth and may require meaningful capital investment during that upfront period. As a limited partner in any fund it is important to keep this in mind, remain patient, not be discouraged by initial low or negative returns. That being said, and we touch on this later on in the article, one must also be realistic.
The J-curve as a natural phenomenon in private equity can lead to significant positive returns over time and affect investment decisions and returns expectations.
Why is it called the J-curve?
Simply put, this phenomena is called the J-curve because when plotted on a chart, it looks like a "J". As a fund uses capital to acquire companies and operate in its early years, the fund value can stay flat or even decline. However, the bet is that investments will gain significant value in later years as they mature and additional rounds of funding and exits occur.
While the three time periods shown above appear discrete, in reality there is often overlap in activities from year to year.
Investment period
Typically during the first few years of a fund's life it is actively investing capital committed by limited partners. During this time the expectation is that the value of the fund will remain relatively stable or even decline as the firm works to deploy capital into attractive companies and draws fees.
Operational enhancement
Once a fund has deployed the bulk of capital it will typically go through a period of working with its portfolio companies to generate value. This may include anything from board level guidance, M&A, executive search, or consulting style operational improvements around supply chain, go-to-market, and more.
Harvest mode
Once the fund has deployed its capital and hopefully created significant value through operational enhancements, it will generally begin selling its stake in portfolio companies to generate returns for LPs. This process can take years given the illiquid nature of private equity as funds look opportunistically for the best time to sell.
Staying realistic
While the J-curve is very real and a pattern that has repeated itself across countless PE and VC funds, investors need to stay disciplined and realistic when looking at a fund. The J-curve can lead to significant returns over time but when diligencing funds it is critical to discern between a fund going through a normal J-curve pattern, and a fund slipping into perpetual decline. At OneFund, when we look at funds for our platform, we are careful to examine prior returns and make sure that current funds are not trending towards sub-par returns as they enter their period of operational enhancement. While there is no such thing as a crystal ball, this can provide increased confidence that a fund can perform.
LPs in a PE or VC fund should be aware the J-curve and how to navigate its impact namely through patience, a long-term mindset, and judicious diligence of funds. The J-curve is a natural phenomenon in PE & VC and when employed well a tool that can be used to generate meaningful returns.