The J curve

Louis Flamand: Maurice explains the famous J-curve phenomenon at every webinar presenting the results of the Altaroc vintages. It's something I've been confronted with throughout my career in private equity. I constantly had to re-explain to senior management the effect of the J-curve on a fund's net performance at the beginning of its life. When you work in private equity, you're familiar with this subject, but when you don't work in private equity, you understand the J-curve effect when it's explained to you, but you tend to forget it pretty quickly. This J-curve phenomenon is present in all institutional portfolios, even the best in the world. It is purely mechanical, and is linked to the fact that, at the start of a fund, the weight of fees is high on a fund with few investments. As the fund expands into more investments, the weight of fees will diminish, and will be amortized by asset appreciation from the 12ᵉ month mark. But rest assured, there are 60 years of institutional history in the private equity world, and it's been 60 years since the J-curve still surprises some. It's perfectly normal and totally mechanical. As a reminder, a private equity fund lasts ten years. It has a five-year investment period, during which it builds up its portfolio, and then a five-year divestment period. Let's focus on the investment period, by way of an example. A fund of size 100 is invested over five years at a rate of 20% per year.

Louis Flamand: At the end of year 1, the fund had only invested 20. At the end of year 2, it has invested 40, at the end of year 3, 60, and so on. Next, let's assume that the fund will take 2% of its fund size of 100 in management fees each year. Clearly, at the beginning of the fund's life, the weight of its management fees is high as a % of the amount invested by the fund, but falls as the investment period progresses. This means that the impact of management fees on the fund's net performance will diminish over time, as the value of investments increases. To illustrate this J-curve phenomenon, we can show you the curve of one of our portfolio managers' historical funds over its 2001 vintage, from September 2001 to June 2003. For almost two years, the fund's net performance was negative - its net-of-all-costs multiple was less than one - due to this J-curve effect. Yet it generated a final performance of three times its net-of-all-costs multiple. The question we're sometimes asked is why? Are management fees calculated on the basis of the commitment if the portfolio is not yet fully invested? In fact, the J-curve is primarily created by the fact that, in private equity, management fees are charged on the basis of the total size of the fund, i.e. all investor commitments during the investment period.

Louis Flamand: These fees enable the teams to conduct thorough research into investment opportunities and perform due diligence on complex assets that are difficult to access because they are unlisted. The teams are therefore compensated for building and managing the fund’s portfolio in its entirety. If fees were calculated based on the amount invested, this could incentivize the Fund manager deploy the fund’s capital quickly in order to increase their management fees. This could lead to a lack of discipline, which could have a far more significant negative impact on the Fund’s final performance. If fees were calculated based on net asset value, the Fund manager also Fund manager encouraged to invest more quickly and even to value assets more aggressively by charging management fees on a fixed basis. During the investment period, the Fund manager effectively encouraged to spread his investments over several years to take advantage of multiple entry points and to value his holdings conservatively. He is not financially incentivized to accelerate his investment pace and potentially lack discipline after the investment period. Fees are then calculated based on the amounts invested in the holdings that have not been sold. The fees are therefore degressive and decrease as holdings are sold. The teams do not receive fees for managing sold holdings. I also sometimes hear it said that the advantage of secondary private equity funds is that there is no J-curve.

Louis Flamand: Indeed, feeder funds purchase investors’ positions in funds, usually at a discount, which results in an immediate upward revaluation of their investment on the books, since the revaluation takes effect immediately. The IRR annualized IRR appears high, but this “bonus” effect occurs only once. The IRR secondary fund then declines significantly over time. As you can see from the J-curve on the graph displayed on the screen, primary funds have a negative IRR , but this improves as investments are made, revalued upward, and then sold. In terms of multiples. Now, due to immediate revaluation, secondary funds that buy at a discount upon entry display a favorable investment multiple in the early years. Conversely, primary funds are subject to the J-curve and exhibit an unfavorable multiple at the outset. Over time and by design, a good primary fund more than compensates for this gap and will typically target a final return of two times the net investment or even more, whereas secondary funds of comparable quality will tend to deliver 1.5 times the net investment. These analyses explain our strategic choice to focus our investments on leading primary funds, as our goal is to deliver optimized performance over the long term rather than in the short term.

‍