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Private Equity: Understanding the J-Curve Effect

As investors grow their wealth, private equity becomes an enticing addition to a portfolio. There are different forms of private equity and each comes with its own risks and potential rewards. To better understand these risks and rewards it is beneficial to be familiar with the J-curve effect.

Primary and Secondary Investors

Primary investors are early entrants into a new business. Primary investors may be investing before there are sales and certainly before the company is cashflow positive, as illustrated above. This is where the term J-curve comes from. (For more, see: What Is Private Equity?)

As the illustration shows, the business is cash flow negative for the first three to four years before trending positive. Investors are buying shares directly from the issuer and this capital is used for expansion efforts, increased efficiency in production, etc.

Primary investors have a goal of earning 10x their initial investment because they know that many of their investments will fail. Investing in a business that has negative cash flow comes with significant risk and as such you need to receive equally significant appreciation opportunity. If you average all of your primary investments the goal is a 20%-30% annual return on your money.

Secondary investors become interested when the company is cash flow positive. It is not hard to see the benefits of a secondary offering, as these companies are easier to value with positive cash flow and result in less risk of outright failing. Secondary investors want to average 7%-15% annual return on their investments, and will often hold the investment until a pre-determined liquidation event like an initial public offering (IPO).

Risks and Rewards of Private Equity

As an investment advisor, I certainly see the benefits of adding private equity to a portfolio. Adding private equity should reduce the portfolio’s overall volatility and increase its risk-adjusted return.

Too often we come across investors that have invested in companies where they were approached by a local business owner or developer. While these situations can work out, they are often taking a portion of your portfolio that should be diversified and making it concentrated in one risky asset. To best understand your risk and potential outcome you need to understand where that business is in the J-curve process.

To take advantage of the benefits of private equity without the over concentration, consider utilizing an asset management company. Many well-known firms like JP Morgan, Goldman Sachs, and BlackRock offer private equity products. The fees usually include a management fee around 1.5% plus a performance fee of 20%. For example, after the investor earns an 8% hurdle rate the management company will earn 20% of the additional profits.

Using these firms raises the cost, but it provides investors with wider diversification and increased due diligence on potential investment targets. They also provide pre-set liquidity options which typically fall in the range of quarterly withdrawals up to no liquidity for 10-12 years. This illiquidity is beneficial for investors as it allows the managers of the fund to focus on long-term returns without worrying about raising cash for daily redemptions from shareholders. (For more, see: Difference Between Private and Public Equity.)