J Curve

The term J curve is used in several different fields to refer to a variety of unrelated J-shaped diagrams where a curve initially falls, but then rises to higher than the starting point.

In private equity, the J curve is used to illustrate the historical tendency of private equity funds to deliver negative returns in early years and investment gains in the outlying years as the portfolios of companies mature.

In the early years of the fund, a number of factors contribute to negative returns including management fees, investment costs and under-performing investments that are identified early and written down. Over time the fund will begin to experience unrealized gains followed eventually by events in which gains are realized (e.g., IPOs, mergers and acquisitions, leveraged recapitalizations).

Historically, the J-Curve effect has been more pronounced in the US, where private equity firms tend to carry their investments at the lower of market value or investment cost and have been more aggressive in writing down investments than in writing up investments. As a result, the carrying value of any investment that is underperforming will be written down but the carrying value of investments that are performing well tend to be recognized only when there is some kind of event that forces the private equity firm to mark up the investment.

The steeper the positive part of the J curve, the quicker cash is returned to investors. A private equity firm that can make quick returns to investors provides investors with the opportunity to reinvest that cash elsewhere. Of course, with a tightening of credit markets, private equity firms have found it harder to sell businesses they previously invested in. Proceeds to investors have reduced. J curves have flattened dramatically. This leaves investors with less cash flow to invest elsewhere. For example, in other private equity firms. The implications for private equity could well be severe. Being unable to sell businesses to generate proceeds and fees means some in the industry have predicted consolidation amongst private equity firms.