The J-curve The private equity (PE) investment narrative has accompanied the expansion of personal markets thus far. This narrative deserves quiet obsolescence.
Here’s why.
The J-curve
Private market funds are typically not fully invested upfront. Rather, investors contractually conform to provide the Investment Manager, over time and upon request, with the capital needed to finance the acquisitions that make up the investment portfolio. Portfolio investments are also not sold , but are sold over time, with the associated money proceeds then returned to investors.
The J-curve describes either the progressive performance of a PE fund, as measured by the interior rate of return (IRR), or the associated net money position of the investor. While it actually is dependent upon how a PE fund uses money over time, the J-curve is more commonly related to the IRR narrative. By pointing to raised future results, the J-Curve story helps mitigate the typically unpleasant effects of the initial downward plunge in IRR – coupled with the high relative weight of costs and costs incurred earlier in a PE fund’s life cycle, within the IRR calculation.
The S-curve
But the J-curve narrative has all the time simplified an underlying sigmoid pattern: an S-curve.
How does the S-curve evolve the J-curve concept? By modeling the results of diminishing marginal returns relative to the self-liquidating nature of personal market transactions. In their various iterations, J-curves don’t accurately describe the influence of time on money flows. Time has a financial cost that makes the more distant distributions less and fewer relevant and results in barely diminishing returns.
Without a sigmoid correction, the J-curve could suggest that “patience” results in extra money or higher returns and that the IRR reinvestment assumption holds true.
To understand and manage the S-curve, a duration-based and time-weighted performance calculation strategy is required. Duration marks the purpose at which the J becomes S and provides the interpretative and predictive shift that sharpens the pricing and risk management perspective.
S-curve, so what?
Investors want to raised understand the danger and return prospects of their private market allocations. They need to know the way it compares to other asset classes. They must also measure and manage their private market timing and overcommitment strategy.
Post-hoc closet indexing comparisons have limited practical application. However, measuring S-curves provides actionable and quantifiable insights by way of each benchmarking and returns.
The portfolio management capabilities of personal market investments are more complex than those of more liquid asset classes. For example, stock portfolios might be built up efficiently and rebalanced more easily. They eliminate private market funding and reinvestment risk in addition to goal allocation challenges.
The J-curve plot assumes annualized and chained IRRs, as is the case with most current P/E indices and metrics. Furthermore, the time-weighted returns (TWRs) calculated using modified Dietz methods are literally just proxies for the IRR. They provide misleading performance information. Neglecting the risk-reducing effect of distributions is like assigning a price of beta=1 to unreinvested S&P 500 dividends: it distorts the portfolio’s risk information.
To illustrate the difference, the steeper line within the chart below shows the return prospects of the money-weighted metrics currently used. The more conservative line reflects actual average dollar creation over time by counting on S-curve and time-weighted permanently adjusted return on capital (DARC) data.
Competing Curves: The S-Curve vs. the J-Curve in Private Equity
The J-curve line represents capital growth if the IRR return were applicable to your entire exposure and reinvestment was immediate. This requires a liquid market and fairly valued NAVs trading at par. The S-curve, however, models the actual dollar formation of the private fund portfolio: it places the IRR within the context of time inside a practical framework for investment speed and overcommitment.
The underlying thesis is supported by data. The long-term mean IRR For example, in line with McKinsey & Company, it’s 13.3%, but US pension funds reported long-term PE returns of 9.3%: A practical regular state overcommitment strategy of 1.4x could be largely confirmed by the 1.5x Net multiplier since inception earned from a serious global PE investor.1
Of course, the performance numbers aren’t the entire story. Private market investing is about greater than just outperformance. The risk-adjusted contribution is just as necessary. This can only be estimated using S-curves and DARC weighted returns.
For this reason, incorporating the de-risking effect of durations – where the S-curves twist – is critical for each accurate benchmarking and effective portfolio management.
1. A 1.5x multiplier and an associated IRR of 13.3% implies a net duration of over 3.2 years, approximated through the use of the formula linking TVPI and IRR: DUR=ln (Multiple)/ ln (1+IRR). Since the online maturity is forward (i.e. doesn’t start at time zero), a reasonably standard three yr ramp-up period increases the overall maturity to six.2 years. In a simplified calculation, the 1.5x multiplier corresponds to the annualized DARC return of 6.6% since inception (i.e. 1.5^(1/6.2)-1 = 6.6%) and again a time-weighted return of 9.3% on a State Invested Capital basis, which requires a 1.4x over-commitment (i.e. normally only 71% of the commitment is invested, subsequently the fund’s DARC return is “leveraged” by the return on invested capital to calculate, 6.6%/0.71 = 9.3%).
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Photo credit: ©Getty Images / Photos by RA Kearton
