The J curve. For some reason, that technical term has become most closely associated with private equity funds more than any other possible field, including medicine and political science.
It has something of a scare-factor to it, plus is a badge of honor too – something unavoidable and to be endured, a bit like Chickenpox. One assumes that during the early age of a fund’s life, one will suffer from it, but then once it’s done, it’s done. Cannot be repeated. After that, it is all plain sailing and profit from there. Which is why when someone mentions that a European firm has somehow “beaten the J curve effect” with its existing fund it must surely pique interest. How? Why? Is this a good thing? Does it even matter?
As everyone knows, the J curve has an ‘effect’ when it comes to private equity funds including real estate vehicles. The valuation of a fund’s investments begin with a fall in the first years and eventually rise to a higher point than the starting point. In other words, initially a loss is made as the fund experiences negative returns but this is followed by (hopefully) significant and prolonged gains, which is obviously a good thing.
Now for the twist. One limited partner in an opportunistic real estate fund in Europe says his general partner is in a position whereby it can say it has eliminated the J Curve. The investor’s analysis is that the way limited partners (LPs) should look at this is as a reflection of the manager’s “execution, de-risking, and asset management capabilities” rather than getting mesmerized by any boost to the internal rate of return. That is because, at the end of the day, the equity multiple remains the same. Indeed, a super harsh analysis might be to welcome the manager’s efforts but to question at the same time the benefits to the LPs. After all, the investors will still get charged a management fee, only it might be in 18 months’ time. In other words, don’t kid yourself as an investor that you have gotten away with paying management fees.
In addition to good management, the reason why a firm might have eliminated the J Curve might also be because debt across Europe for the right sponsor is historically cheap at the moment. Attractive financing could be driving cash-on-cash. That latter point implies that other managers besides the unidentified firm are also avoiding the J Curve, so the question becomes how much of each relevant factor is responsible? Is it more a function of the market in which the debt markets are favorable to the right borrower?
There are a few reasons for the J Curve to exist at all. It happens when fees are charged on committed capital that takes a number of years to draw down. The obvious way to get around that is just to have fees on invested capital, though generally there will some fee, maybe a split fee, on committed capital. It also happens when there are significant establishment costs of a fund especially in a heavy jurisdiction and for complex fund structures. The third possibility is assets for opportunity fund managers will likely take a hit early on, not only because of transaction costs but also the nature of the assets which will not necessarily increase in value until the fulfillment of a business plan including gaining pre-lets. Only then would a valuer adjust the valuation up.
The investor’s analysis of the GP in question here is that the manager has simply had a great 18 months. It is down to a combination of buying assets with current passing yield while being very savvy at tying up sellers in various contingent conditions so the asset is in better condition at the point the money is actually transferred.
Whatever the true or over-riding factor is, one can hazard a guess that the manager in question will want to max out on its position when it comes to raising the next fund. Indeed, you can be sure that as the firm in question goes about raising its next pan European fund in the series, it will be sure to point out the pretty aspect of its existing fund that has eliminated the J Curve effect. It might be a bit cosmetic, but it sure looks good! And by the way, if you are wondering which manager this is, I am afraid I am sworn to secrecy. But then again, LPs that have been pitched by the company in question probably have a shrewd idea. No man is an island.
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